Contents

1. Chapter 1: Introduction

1.1 The Special Case of Banking Sector: Theory of Organization

1.2 The Bank as a Governance Mechanism

1.3 The Presupposed Effectiveness of the Bank as a Governance Mechanism

1.4 The Rise of Universal Banking and Its Effect on Banking Risk

2. Chapter 2: Corporate Governance in Banking Sector

2.1 Corporate Governance of Banks: The Guiding Principles

2.2 Governing Principles on Banking Supervision

2.3 Corporate Governance of Banks

2.4 Risk Avoidance or Risk Taking

3. Chapter 3: The Specificity of Banking Governance

3.1 An External Dimension

3.2 An Internal Dimension

3.3 Financial Crisis

3.4 The Banking Governance on the Eve of the Crisis?

3.5 The First Effects of the Crisis on Governance

3.6 The Effects in the Longer Term

4. Chapter 4: Enron and WorldCom Fraud: Some Reflections on Corporate Governance Failures

4.1. The Nature of Credit Risk

4.2 Default Risk Mitigation

 4.3. What Happened When Enron Filed For Bankruptcy?

4.4. Misuse of Credit Derivatives

5. Chapter 5: Regulation and Supervision of the Financial System

5.1 Asymmetric Information, Adverse Selection and Lemons

5.2 Government Regulation and Supervision of Indirect Finance

5.3 The Expanding Role of the Federal Reserve as a Regulatory and Supervisory Agency

5.4 Corporate Governance Norms of Different Countries

A. Impact of the Board of Directors on Performance of Tunisian Banks

B. French Banking Sector: A Universal Banking Model
C. Japan’s Banking Industry: A Social Exchange Perspective on Governance

Chapter 6: Conclusion

Bibliography
LIST OF ABBREVIATIONS

BIS Bank for International Settlements

CEO Chief Executive Officer

FSAP Financial Sector Assessment Program

FSA Financial Services Authority

FSAP Financial Services Action Plan

IGC Inter-Governmental Conference

IMF International Monetary Fund

IOSCO International Organization of Securities Commissions

LCB Land Central Bank

LLR Lender of Last Resort

MLG Multi-Level Governance

MPC Monetary Policy Committee

NCB National Central Bank

OECD Organization for Economic Co-operation and Development

PSBR Public-Sector Borrowing Requirement

SIB Securities and Investments Board

SRO Self-Regulatory Organization

TEU Treaty on European Union

BCBS Basel Committee on Banking Supervision

BCCI Bank of Credit and Commerce International

BEPG Broad Economic Policy Guidelines

BSC Banking Supervision Committee of the European System of Central Banks

CBC Central Bank Council

CCBG Committee of Central Bank Governors

CEBS Committee of European Banking Supervisors

CESR Committee of European Securities Regulators

CPSS Committee on Payment and Settlement Systems

CRD Capital Requirements Directive

ECB European Central Bank

ECJ European Court of Justice

EMI European Monetary Institute

EMS European Monetary System

EMU Economic and Monetary Union

ACCA Association of Chartered Certified Accountants

CASC China Accounting Standards Committee

CASE Cairo and Alexandria Stock Exchange

CBCA Canada Business Corporations Act

CCCE Canadian Council of Chief Executives

CCGG Canadian Coalition for Good Governance

CDIC Canadian Deposit Insurance Corporation

CEO Chief Executive Officer

CFO Chief Financial Officer

CGWG Corporate Governance Working Group

NSCG National System of Corporate Governance

NYSE New York Stock Exchange

SIDO Securities (Insider Dealing) Ordinance

SME Small- and Medium-sized Enterprises

SOE State-Owned Enterprises

CHAPTER 1: INTRODUCTION

1.1. THE SPECIAL CASE OF BANKING SECTOR: THEORY OF ORGANIZATION

In recent years, sovereign debt crises have multiplied in the West. Creditor intervention in the
debtor's operation is frequently discussed in the discussions on the fiscal austerity imposed on
the countries concerned. The subject, which is not new, remains an essentially macroeconomic
concern. This paper takes a "management" approach and considers that it renews the debate on
the role, postulated for nearly 30 years, of corporate governance played by the bank. According
to Agency theorists1, governance is seen as the set of mechanisms used to constrain managerial
decisions. It is therefore a question of dealing with the bank's actions on the strategy and
operational management of the company which it is helping to finance2.

The main areas in which the banks act concern the company's financial and investment policies.
Thus, the explanations of the Asian financial crisis of the years 1990-1996 establish the
responsibility of capital and bank credit relationships for debt overhang and underinvestment3.
Similarly, the debate on the international performance of US firms in the 1980s highlights the
role of shareholder banks in sacrificing intangible investment4.

This chapter discusses the implications of the bank establishments as a corporate governance
mechanism for banking regulation. It is based on the principle that the activity of banks within
the enterprises financed is an opportunity to increase the financial risk (credit and capital risk) to
which they are exposed. It should be recalled that risk-taking underpins the design of bank
standards and is subject to a dual perspective of apprehension:

1
DeFerrari, Lisa M. and David E. Palmer (2001), ‘Supervision of Large Complex Banking Organizations,’ Federal
Reserve Bulletin, 80, 47–57
2
Francis J. et Smith A. (1995), “Agency Costs and Innovation: Some Empirical Evidence”, Journal of Accounting
and Economics, Vol.19, p.383-409.
3
Lympaphayom P. et Polwitoon S. (2004), “Bank Relationship and Firm Performance: Evidence from Thailand
Before the Asian Crisis”, Journal of Business &Accounting, Vol.31, p.1577-1600.
4
Park S. (2000), “Effects of the Affiliation of Banking and Commerce on the Firm’s Investment and the Bank’s
Risk”, Journal of Banking &Finance, Vol.24, p.1629-1650.
The first is marked by the risk being confused with bank loans and or the bank's direct or non-
direct participation in the company's share capital5. This logic, which consists in reducing risk to
the activity of banking intermediation, is historical and above all privileged in the main efforts to
standardize banking, which are: the 1988 agreements, known as the Basel I agreements, limited
to the activity of bank loans; the 1996 amendment, which considers the acquisition of holdings
referred to above; the 2004 agreements, better known in terms of Basel II, build on previous
initiatives by incorporating operational risk. The second perspective is understandable given the
bank's ability to increase the financial risk to which it is already exposed when it interferes with
the management of debtor companies. It is based on the argument that this interference allows
the bank to change its own risk profile by, for example, directing the company to adopt a risky
business policy.

In the latter perspective, the author highlights the challenge of strengthening prudential
standards. The proposal is part of the perspective opened by these references still not developed.
The above-mentioned interference by the bank in the management of the company financed is
part of a banking strategy aimed at circumventing regulation or taking advantage of its
shortcomings to optimize risk. Banks, like any other organization, are therefore not passive vis-à-
vis external or regulatory constraints. They consider that the holding of own funds, as required
by the regulator, generates an opportunity cost and is therefore irrational6.

However, the theory behind the tightening of banking supervision rules seems to be based on a
presupposition: it concerns the ability of the bank, whether it is a shareholder or a bondholder, to
induce the undertaking concerned to adopt a risky policy. The argument is therefore the result of
an ideological bias which raises two types of new problems in general. The first is of a
conceptual nature and stems from the incoherence of the financial orthodoxy theory according to
which the shareholder, unlike the bond-holder, has the right to define and control the
management of the company. The second, which is of a pragmatic nature, concerns the difficulty
of identifying the activity to force if banking regulations are to be strengthened.

5
Demsetz R., Saidenberg M., Strahan P. (1997), “Agency Problems and Risk Taking at Banks”, Banking Studies
Department, Federal Reserve Bank of New York, pg. 37
6
Jappelli T., Pagano M. et Bianco M., “Courts and Banks : Efects of Judicial Enforcement on Credits Markets”,
Journal of Money, Credit and Banking, Vol.37, no 2, p.223-244.
Taking this dual concern into account enriches the debate on adapting banking standards to the
realities of developing economies. One of the main reasons cited concerns the evolution of
competition in local banking sectors 7 . Concern for competitiveness seems to push banks,
according to Tioumagneng8, to establish credit and capital links with microfinance and even
venture capital institutions. In the banking regulatory bodies in general and the Central African
Banking Commission in particular (COBAC, 1993), the control of these relationships is a
constant concern. The scarcity of specialized academic studies underlies our concern to detach
ourselves from the media noise created around these reports and to deal with the problem of the
banking risk they raise.

1.2. THE BANK AS A GOVERNANCE MECHANISM

The theoretical consensus on the bank's vision as a governance mechanism disappears when one
looks at the effectiveness of this arrangement in terms of the effective orientation of the
corporate strategy. However, this effectiveness is presupposed by the paradigm which postulates
that banking risk is also taken indirectly.

Neo-classical financial theory is built on the idea that borrowers lack power over creditors.
Indeed, one of the fundamental assumptions of the 1958 financial structure neutrality thesis
defended by scholars is that managers manage in the best interests of shareholders and therefore
have no discretion. The relative power of creditors is derived from the rationing model that is
fundamental to the development of the traditional financial economy.

On the basis of this model, the explanations of the financial structure of enterprises highlight
external factors, including the opportunism of creditors. The presence or absence of bank
resources in this financial structure is therefore interpreted as being exclusively dependent on the
bank and not on the undertaking concerned. In a way, this view is close to the thesis of
erogeneity of the mechanisms of governance. However, it is illusory to think that company
policy is dictated by market forces alone.

7
Greenspan, Alan (1990), Address in ‘Proceedings of A Conference on Bank Structure and Competition,’ Federal
Reserve Bank of Chicago, 1–8.
8
TIOUMAGNENG T.-A. (2012), “Bank Behavior and Debt Research In Management”, Sciences Management,
n°89, p. 81-99.
The alternative thesis, known as the endogeneity of governance mechanisms, has been defended
since Demsetz's study in 19839. In this perspective, the authors show the importance of variables
internal to the company in explaining its financial choices. They place particular emphasis on
managerial discretion, i.e. on the active nature of the firm's management in its financial and
investment choices. The argument results from the realism of the rationing model and justifies
the firm's ability to boycott bank offerings.

The coexistence of the theories of endogeneity and exogeneity of the company's financial
structure raises at least two types of problem. The first is the difficulty of knowing whether the
bank's presence as a bondholder or shareholder in the company is the result of a deliberate choice
by the company. The second refers, according to the authors who confuse the risk with bank
loans, to the possibility that this presence is dictated to the enterprise by the banks concerned.
The treatment of the problem requires a research-intervention in which the managers of the
company can be given an opportunity their opinions. However, this is not the approach taken in
this study, which instead merely examines, in the light of the financial link between the bank and
the undertaking, the influence which the bank has on the management of the undertaking. The
approach is based on the assumption that the bank is effective as a control mechanism of the
partner company.

1.3. THE PRESUPPOSED EFFECTIVENESS OF THE BANK AS A GOVERNANCE

MECHANISM

The argument of neutrality of the financial structure defended by Modigliani and Miller in 1958
is the subject of sharp criticism. The unreality of the idea is particularly postulated by showing
that the opportunism of the creditors leads them to guide the debtor's financial or investment
policies. The bondholder as well as the shareholder is thus perceived, in particular in the sense of
Jensen's "Free Cash Flow" theory, as having the controlling power of the partner company.
Nevertheless, the way in which he uses this power is the subject of heated controversy10.

9
Harold Demsetz, Belen Villalonga , “Ownership Structure and Corporate Performance”, Journal of Corporate
Finance 7, 1983, pg. 209–233
10
Morck R., Nakamura M. & Shivdasani A. (2000), “Bank, Ownership Structure, and Firm Value in Japan”, The
Journal of Business, Vol.73, p.539-567.
According to financial orthodoxy, bond status gives its holder, a considerable property right in
the debtor's assets. On the other hand, the corresponding creditor has only a limited right, unlike
a shareholder, to control these assets or to have direct influence on the management decisions of
the debtor. It is in fact assumed that the bondholder, unlike the shareholder who bears a residual
risk, has the assurance of debt servicing by the borrower. Based on this assurance, it is shown
that the bank may not be concerned with the way in which the debtor company uses the loans
granted or the nature of the business carried on by the debtor. However, according to some
analyses, this indifference seems inconceivable when the loans granted by the bank are, for
example, "revolving", long-term or of a considerable amount11. In other words, in each of the
cases cited, it is likely that the bondholder bank will be active in terms of the policy direction of
the debtor to ensure its profitability or solvency.

Shareholder status, on the other hand, allows its holder to control directly or indirectly, with
direct control operating through general meetings and indirect control via, in particular, the board
of directors and the rights proxy mechanism. The right of control enjoyed by the shareholder is
explained by the residual risk referred to above, i.e. the uncertain nature of his remuneration,
which depends on the profitability of the undertaking. It is therefore recognised that the
shareholder-Bank is able to instruct the management of the partner company to avoid carrying
out risky or unprofitable activities, the aim being to ensure that its dividends are paid both in the
long term and in the short term12.

However, in some contexts, the reality appears to be different. The shareholder banks, given the
risky nature of the company's policy to be promoted, thus form a heterogeneous group. At least
three major factors help to explain their decision to favour or not to favour the commitment of
the partner companies to carry out risky activities.

The first, following the traditional governance approach is the divergence of corporate and
shareholder risk preferences. This shows that managers are likely to avoid R&D activities which,
although they create value over time, given the uncertainty over the duration of their mandate or
their need to reveal their quality in the labour market in the short term. The financial economy

11
Seifert B. & Gonenc H. (2012), “Creditor Rights and R&D Expenditures”, Corporate Governance: An
International Review, Vol.20, p.3-20.
12
Sherman H., Beldona S. & Joshi M. (1998), “Institutional Investor Heterogeneity: Implications for Strategic
Decisions”, Corporate Governance, Vol. 6, p.166-173.
treats the problem in terms of "managerial shortsightedness" and relies on the argument that the
operationalization of the strategy, as defined by the Board of Directors representing shareholders,
is a prerogative of management. The second factor concerns the extent of the relations between
the two actors involved. This is the idea that the maintenance of non-credit links with the firm
leads the bank to support any risky or non-risky business policy decided by the firm's
management. The concern to preserve these links, which are sources of additional income for the
bank, justifies the bank's abstention from upsetting its managers. The latter refers to the amount
of the company's capital that is held by the bank. In this context, the importance of capital
appears to be a solution to the problem of ‘Stowaway’. It is therefore supposed to place at a
disadvantage the shareholder Bank's incentive to use the link in relation to the control of
management decisions on investment in particular.

1.4. THE RISE OF UNIVERSAL BANKING AND ITS EFFECT ON BANKING RISK

Since the late 1980s, the trend has been towards universality in all banking systems of
industrialized countries. By virtue of that reason banks are allowed to carry out a very wide
range of operations. An increasing number of economists emphasize the potential benefits of a
universal banking system: the possibility for banks to diversify their activities, the reduction of
agency and information costs, the more effective support from banks to enterprises in the event
of financial difficulties and higher amounts of bank credit13.

However, there is the question of the risks inherent in the new licensed activities and the problem
of the regulation of these activities. Indeed, the many bank failures that have occurred in all
industrialized countries over the past two decades suggest that some banks have taken excessive
risks and that their risk management policies have been flawed. In particular, the banks holdings
in the capital of non-financial enterprises would encourage them to take more risks, incentives
which are all the more important as they are protected by a deposit insurance system. In fact, by
taking stakes in the capital of a firm, the bank's interests are no longer only those of a creditor
but also those of a shareholder. While, as a creditor, it has a preference for non-risky projects, it
prefers, as a shareholder, to invest in risky projects. The interests of the banks are then the same

13
Masciantonio, Sergio and Tiseno, Andrea, “The Rise and Fall of Universal Banking: Ups and Downs of a Sample
of Large and Complex Financial Institutions Since the Late ‘80s (April 1, 2013)”. Available at SSRN:
http://dx.doi.org/10.2139/ssrn.2172211 (last visited 25 March 2019)
as those of the shareholders or managers, leading to conflict of interests and choice of a riskier
investment strategy.

John and Saunders 14 conclude, respectively, the optimality of a loan-to-equity financing

agreement and the existence of a decreasing relationship between the risk of lending and equity.
of a bank and its level of participation. Their result is based on the existence of a double effect of
the participations on the banking risk. First of all, the participations involve a higher risk for the
bank insofar as they give rise to a random remuneration, which is a function of the residual profit
of the firm. Then, when the share of the bank's financing in the form of participation increases,
the nominal value of the loan decreases and the firm then sets up a less risky investment policy.
Santos and John, John and Saunders show that the lower risk that results from the firm's behavior
more than offsets the increased risk of ownership.

If we take into account only the first effect of equity on banking risk, there is a growing
relationship between a bank's level of participation and the risk of its assets. They show that the
higher ‘the level of participation of the bank, the greater the incentive to defraud’. In fact, firms
can choose between two types of Projects: a first project requiring an investment amount greater
than the unit and which is expected to bring in a high income; a second project where the initial
investment is less than the unit and where the expected income is low. As a shareholder,
universal banks benefit from some of the misappropriated wealth when the firm decides to invest
in the second project, while the funds allocated allow it to invest in the first project. Universal
banks can thus be encouraged to favour the firm's choice of the second project, which is more
risky and less profitable than the first. The result is greater instability for universal banking
systems15.

“The issue of bank governance is strongly related to the market discipline approach.
Depositors, debt-holders and shareholders can exert a disciplinary influence on banks'
risk-taking by raising the funding premium on deposits, debt, and equity-the problem
traditionally addressed in the moral hazard literature based on agency theory. On one
hand, bank managers with strongly bank-specific human capital may be reluctant to take

14
Kose John, Teresa A. John and Anthony Saunders, "Universal Banking and Firm Risk-Taking", Journal of
Banking & Finance, 1994, vol. 18, issue 2, 307-323
15
GEYFMAN, V., & YEAGER, T. (2009). “On the Riskiness of Universal Banking: Evidence from Banks in the
Investment Banking Business Pre- and Post-GLBA”, Journal of Money, Credit and Banking, 41(8), 1649-1669.
 up risky projects. However, managers with equity stakes in their bank may show a higher
propensity to risk than managers without equity participations”.

Moreover, managers, if not monitored effectively, may be tempted to behave as 'empire

builders'-that is, push aggressively the growth of the bank in order to expand their control over
resources, which may destroy shareholders' value. On the other hand, limited liability gives share
holders strong incentives to increase risk at the expense of depositors and bondholders-the so-
called 'risk shifting' phenomenon. Moreover, controlling shareholders with large cash-flow rights
will be interested in maximizing the bank's franchise value; therefore they can be expected to
monitor managers actively in order to increase their risk-taking propensity if they suspect the
latter of being too conservative. On the contrary, ownership structures based on minority control
(such as pyramiding and cross-ownership) may lead to excess risk-taking, as the separation of
control rights from cash-flow rights may distort shareholders' incentives in favour of projects
with larger private benefits of control rather than projects with higher total value. Shareholders'
interests can also be aligned with those of managers if the latter give in to opportunistic behavior
to maintain and expand their own power, which may lead to excess risk concentration, sluggish
management, and the preservation of organizational inefficiencies (for example, when banks
expand lending volumes in order to cover operation costs, thus taking in further risk). As
emphasized in World Bank studies, this problem can be magnified by the fact that informational
asymmetries between insiders and outsiders are sharper in banking than in other sectors, for
greater opaqueness not only makes a bank's performance difficult to measure and easier to
manipulate in the short run, but also increases the difficulty of designing contracts which align
managers' interests with those of shareholders16. Distortions can also originate from conflicts of
interest-the classic case being the assumption of bank equity stakes by corporate firms financed
and partly owned by the bank. As suggested by the other literature as well, conflict of interest
can prove especially serious in the case of firms hit by a negative shock and financial distress17.

The effectiveness of market discipline mechanisms can be heavily influenced by institutions such
as the legal treatment of investors, the transparency of the economic environment and the

16
Levine, Ross. 2004, “The Corporate Governance of Banks: A Concise Discussion of Concepts and Evidence”,
Policy Research Working Paper; No.3404. World Bank, Washington, D.C., World Bank.
17
Bhattacharya, S., Arnoud W. A. Boot, & Thakor, A. (1998), “The Economics of Bank Regulation”, Journal of
Money, Credit and Banking, 30(4), 745-770.
existence of deposit insurance. Theory is ambiguous as to predictions of the impact of investor
protection on risk-taking. Some suggest, for instance, that poor investor protection, by increasing
the magnitude and importance of private benefits to insiders (both shareholders and managers),
provides incentives to privilege conservative investment policies 18 . However, it can also be
argued that poor investor protection, by favoring the emergence of dominant shareholders and
minority control, may lead to excess risk-taking. The level of disclosure and transparency should
also be taken into account. In an opaque environment, some suggest, universal banks may have
strong incentives to 'stuff' unplaced securities of controlled firms into hidden accounts, or
transfer debt-related risk to unsuspecting outside investors by issuing securities of a firm whose
bankruptcy risk has increased to the private knowledge of the banker19.

A large body of theories of financial intermediation based on asymmetric information argues that
financial systems in which universal banks provide the bulk of external funds to firms are better
suited to effectively dealing with long-term growth and moral hazard problems 20 . In the
corporate governance literature this view translates into the alleged superiority of 'insider
systems', typical of Germany and Japan, as opposed to the Anglo-Saxon 'outsider system'. An
'insider system' of corporate governance is basically dominated by banks which engage in the
full range of corporate banking services (including investment banking), develop long term
relationships with their corporate clients, and own equity stakes in them. The 'insider' model is
therefore characterized by the integration of relationship banking into universal banking: a
pattern in which universal banks engage in multiple interactions with their corporate customers
across products and over time; systematically invest in extracting proprietary information from
firms; and exert active corporate governance both as debtors and equity holders. Insider banks
with an information monopoly are better positioned to extract monopolistic rents from captive
borrowers, who therefore face a hold-up problem;" this problem, however, can be mitigated by

18
Palazzo, G. & Rethel, L. J Bus Ethics (2008) 81: 193. https://doi.org/10.1007/s10551-007-9488-z (last visited 25
March, 2019)
19
Bhattacharya and Anjan Thakor, “Contemporary Banking Theory”, Journal of Financial Intermediation, 1993,
vol. 3, issue 1, 2-50, Available at SSRN: https://ssrn.com/abstract=5670 (last visited 25 March, 2019)
20
Daniel Tsiddon, “A Moral Hazard Trap to Growth”, International Economic Review, Vol. 33, No. 2 (May, 1992),
pp. 299-321, Available at https://www.jstor.org/stable/2526896 (last visited 25 March, 2019)
the fact that banks assume, either implicitly or explicitly, special responsibilities in the case of
corporate distress, in order to preserve or reinforce their rent opportunities in the long term 21.

The implications of insider systems for banks' risk-taking and financial stability are a major
source of theoretical controversy. Some studies regard the use of a debt-equity mix as an optimal
strategy for a bank to access customer-specific proprietary information and reduce moral hazard,
particularly in opaque corporate systems with poor disclosure requirements and low
accountability.' In turn, the pursuance of rents based on information creates strong incentives to
invest in integrate monitoring; this effect is possibly stronger when firms have an exclusive
relationship with the bank for the provision of different financial services. As a consequence, due
to banks' commitments to long-term relationships (which expand the investment horizon of
firms) and consistent monitoring of financed firms, insider systems are believed to control risk-
taking more effectively and promote the efficient allocation of resources in the long run. In this
view, economic contracts that reduce the fees of records and corporate governance also are
presupposed to reduce the fee of external finance and stimulate funding, accordingly contributing
to monetary increase in the end. In the same fashion, securities underwriting by banks is believed
to improve the efficiency of financial markets by generating a net-certification effect.

21
Denis, D., & McConnell, J. (2003), “International Corporate Governance”, The Journal of Financial and
Quantitative Analysis, 38(1), 1-36.
CHAPTER 2: CORPORATE GOVERNANCE IN BANKING SECTOR

Following the banking crisis and the publication of the Walker Report (2009) 22 in the U.K.,
international organizations have issued guidelines to improve corporate governance of banks
and, more specifically, risk management, all with a common goal: ‘NEVER AGAIN’ 

The international relationships vary widely as to what should be the main corporate governance
objective of the banks, with some advocating a shareholder approach and others a stakeholder
approach. In addition, these reports focus exclusively on risk avoidance, providing little guidance
on how boards should define an acceptable level of risk. In this chapter, author has focused on
the debate of corporate governance of banks, based on economics and finance.

2.1. CORPORATE GOVERNANCE OF BANKS: THE GUIDING PRINCIPLES

Corporate governance has been defined as: According to the OECD principles on corporate
governance, "corporate governance refers to the relationship between the management of a
company, its board of directors, its shareholders and other stakeholders. It also determines the
structure by which the objectives of an enterprise are defined, as well as the means of achieving
them and of monitoring the results obtained” 23 . Shleifer and Vishny offer a more concise
definition: "corporate governance is concerned with the way in which capital providers finance
companies and ensure their own return on their investment”24.

In a market economy, several types of governance mechanisms can exist and co-exist. In some
countries, such as Germany, it will also be composed of employee representatives. In a
cooperative structure, such as a credit union, it may include client representatives: borrowers and
depositors. In several countries, the members of the Board of Directors of savings banks are
locally elected politicians. It is striking to observe, from a reading of the international proposals
for better corporate governance, that there is a divide between two camps which advocate
respectively a vision of shareholder-based corporate governance and a vision of stakeholder-

22
ICAEW, Corporate Governance Codes and Reports, “A Review Of Corporate Governance In UK Banks And
Other Financial Industry Entities (The Walker Report)”, Retrieved from
https://www.icaew.com/technical/corporate-governance/codes-and-reports/walker-report (last visited 25 March,
2019)
23
OECD Principles of Corporate Governance (2004)
24
Shleifer, A. and Vishny, R. W., A Survey of Corporate Governance. The Journal of Finance, 52: 737-783.
doi:10.1111/j.1540-6261.1997.tb04820.x (last visited 27 March, 2019)
based governance. According to the First view, corporate governance should benefit
shareholders, who are the owners of the company. According to the second view, corporate
governance norms should take into account the interests of both shareholders and other
stakeholders as well, which include in general depositors, employees, customers, taxpayers and
society. These two views are discussed below.

The Walker Report (2009, p. 23), which is based on the UK Companies Act, advocate for
shareholder’s view: “the role of corporate governance is to protect and develop the interests of
shareholders through the establishment of a company's strategic direction and through the
appointment and oversight of a management competent to achieve these objectives.” But this
does not mean that other stakeholders should be ignored. Appendix 3 of the Walker Report (Pg.
135-136) a list of sound management principles.

"In order to promote the success of a business, directors must consider, among other things, the
following six factors:

 the likely long-term consequences of any decision ;

 the interests of the company's employees ;
 the need to maintain commercial relationships with suppliers, customers and others (duty
of loyalty) ;
 the company's impact on the community and the environment ;
 interest in maintaining a reputation (long-term market position) ;
 The need to act fairly among the members of the company”.

Nevertheless, according to the Walker Report, a single objective should be pursued by the
directors of a company: ‘to promote the prosperity of shareholders, who are the owners of the
company’. This is in sharp contrast to the proposals for better corporate governance of banks
made by the Basel Committee (2010) and the European Union, which favour the stakeholder
approach. For example, the Basel Committee's principles for strengthening corporate governance
(2010, pg. 5 and pg. 10) states: "the manner in which the board of directors and the executive:
  set out the bank's strategy and objectives ;
 determine the bank's risk tolerance and appetite for risk ;
 lead the ongoing operations of the bank ;
 protect the interests of depositors, respect the obligations of shareholders and consider
the interests of other recognized stakeholders ;
 align their activities and behavior with the perspective that the bank will operate in a
safe and sound manner, with integrity and in compliance with applicable laws and
regulations”.

They also state: "in carrying out these responsibilities, the board of directors should take into
account the legitimate interests of shareholders, depositors and other relevant stakeholders”.

While Walker Report talks about a single point agenda for corporate governance, the Basel
Committee Report and European Union advocate for multi-objective agenda; that is to say the
protection of interests of all stakeholders.

As discussed above, different forms of corporate governance can prevail in a market economy.
The question is what form leads to the most efficient outcome for society and to the best banking
system, with a supply of quality financial services at acceptable prices. Given that some banks
have taken excessive risks that have led to huge losses, costly bailouts for taxpayers, large
budget deficits and rising unemployment, the dominant view is that there should be pressure on
the boards of directors to take into account not only bank shareholders, but also depositors and
society as a whole.

While public response and required modifications in corporate governance are valid, they should
not interfere with a lucid and goal analysis of the merits of various styles of governance, not only
at the level of banks, but also at the extent of banking supervisory and supervisory government.
Indeed, the need for efficient banking regulation and supervision has been recognised for many
years and one of the tasks of banking supervisory and control authorities is to develop a sound
and safe banking system. We begin with the government of the banking supervisory and control
authorities, before turning to corporate governance through the banks ' boards of directors.
2.2. GOVERNING PRINCIPLES ON BANKING SUPERVISION

With regard to the solvency and stability of banking systems, they require the independence and
responsibility of banking supervisors, as well as necessary legal methods to mitigate bank losses.
Regulators most often advocate for codified laws for this practice. Supervisors, based on custom,
practice and appreciation of rules and regulations, monitor what should be done and how. The
need for independence and accountability of banking supervisors was addressed by Dermine and
Schoenmaker (2010)25. Unlike bank CEOs, very few national supervisors have been asked to
resign in the last six years, which inevitably calls into question the responsibility and
independence of bank supervisors. In several central and Eastern European countries (ECB,
2007), for example, banks have been allowed to lend heavily in foreign currencies (mainly Swiss
francs, Euros and yen) in the individual mortgage market. This created a critical source of
systemic risk, as a devaluation of the nearby foreign money could increase the default charge
throughout the banking machinery.

Why this source of systemic risk was allowed to develop? It is easy to imagine that, in the eyes
of many ministers, a strong real estate market would help sustain the economy, employment, real
estate developers and the public budget, with higher tax revenues. It would take a very
courageous banking supervisor to put a stop to foreign currency loans, thus slowing the economy
and harming property developers. The FSAPS have been in place since 1999, yet they have not
been effective in preventing the crisis. It is striking to note that, following the Irish banking crisis
of December 2010, European banking supervisors acknowledged that the European stress tests
conducted in July 2010 had been too lenient. Since it was not a lack of regulation that
contributed to the crisis, but rather its poor implementation by banking supervisors, a
strengthening of the latter's responsibility seems essential..... This need to evaluate banking
supervisors calls for the development of performance measures. In the case of central banks,
these performances are simple to identify: inflation or inflation expectations. In the case of
banking supervision, they are more complicated to establish since no single Financial Stability
Index is available. A comparison can be made with a bank's risk Department assessment for
which no single bank Risk Index exists. In order to assess performance, quantitative data (such

25
Dermine, J. and Schoenmaker, D., “In Banking, Is Small Beautiful?”, Financial Markets, Institutions &
Instruments, 19: 1-19. doi:10.1111/j.1468-0416.2009.00152.x (last visited 15 March, 2019)
as the spread of CDS – credit default swaps – of banks or subordinated debt and the information
on the probability of bank default provided by external companies) will have to be combined
with 'subjective' data (such as the assessment of regulation and supervision by an expert panel).
A clear link between results, on the one hand, and promotion/remuneration, on the other, seems
necessary for the establishment of the right incentive structure.

The second tool available to strengthen financial stability is the development of a legal
mechanism that forces debt holders to bear bank losses. It is only when debt holders are at risk
that they spend resources to analyze the risks taken by the bank. Two mechanisms have been
proposed: equity financing, which allows losses to be absorbed on the basis of the so-called
"Going Concern" principle (as in the case of shares and contingent convertible bonds), or a quick
resolution mechanism, which may require creditors or depositors to contribute. The latter would
be facilitated by "testamentary dispositions", plans that facilitate rapid resolution in the event of
financial difficulties26.

In other words, appropriate mechanisms can be put in place to reduce the likelihood of a banking
crisis and its potential consequences for the public finances. While the government of banking
regulation and supervision allows for independence and accountability, the debate on corporate
governance of banks can focus on the efficiency of financial institutions and economic
development.

2.3. CORPORATE GOVERNANCE OF BANKS

Three arguments can be advanced in favour of the shareholder approach to corporate

governance, focusing on organizational efficiency, entrepreneurial innovation and economic
well-being.

The first argument refers to the efficiency of an organization. Pursuing a single goal –
shareholder prosperity – provides a clearer focus than pursuing multiple goals. To quote the
Bible: "no one can serve two Masters.” Or, as the old maxim goes, "to aim for more than one
goal, we achieve none." Since it is difficult to develop an indicator of the aggregate well-being of

26
Dermine, Jean, “Bank Corporate Governance, Beyond the Global Banking Crisis” (March 9, 2011).
stakeholders, there is a risk of a lack of accountability on the part of Management, which may
prefer to maximize its own well-being, for example by building an empire27.

Jensen develops the notion of "enlightened value maximization”: "the basic principle of
enlightened value maximization is that we cannot maximize the long-term market value of an
organization if we ignore or abuse any important stakeholder. We cannot create value without
good relationships with customers, employees, financial supporters, suppliers, regulators and
communities”28.

Maximization of shareholder value is the goal of performance, but to achieve it, common sense
dictates that we take care of stakeholders; in the banking sector, this is called the duty of loyalty
to depositors and customers. Moreover, the useful transformation of maturities by banks by
financing illiquid assets through short-term deposits creates a risk of massive disengagement of
depositors from the bank. To reduce the likelihood of costly disengagement, a bank is
encouraged to protect short-term depositors with a buffer of long-term securities, such as stocks
or subordinated debt, capable of absorbing going concern losses. The protection of short-term
depositors is thus compatible with the maximization of shareholder value.

The second argument relates to economic development and risk taking. The progress in our free
market societies is partly due to the fact that private companies take risks, in accordance with the
Schumpeterian vision of the role of innovation by private companies. But risk-taking necessarily
involves the occurrence of failures. If one of the objectives of corporate governance is to serve
debt holders and banking regulators, then risk should be minimized by avoiding actions that
could lead to default. Other things being equal, a reduction in risk will increase the value of the
debt and reduce the liability of the deposit insurance system.

Many innovations have taken place in the banking sector, such as microfinance, home loans to
high-risk borrowers; high-risk bonds issued by low-quality companies, financial derivatives,
guaranteed funds, credit derivatives and alternative investment vehicles. In some cases, they
have led to significant losses and failures, but few will deny the usefulness of derivatives in
hedging risks or designing safety.

27
Jean Tirole, “The Theory of Corporate Finance”, Princeton University Press, January 2006.
28
Jensen, M. C. (2001), “Value Maximization, Stakeholder Theory, and the Corporate Objective Function”, Journal
of Applied Corporate Finance, 14: 8-21. doi:10.1111/j.1745-6622.2001.tb00434.x (last visited 27 March, 2019)
The third argument, from welfare economics, is that under certain conditions (such as
competitive markets), the pursuit of the maximization of shareholder value maximization leads
to economic welfare with the equalization of the marginal revenue and marginal cost. Well-
identified frictions, such as imperfect competition, imperfect information or imperfect income
distribution, require public intervention. Similarly, in the banking sector, the fragile nature of the
industry due to the useful transformation of short-term deposits into illiquid assets requires
public intervention (deposit insurance, central banks acting as lenders of last resort), but these
frictions do not necessarily call for a change in corporate governance.

A stream of scholars favour a dual system of government based on clear objectives and
accountability: the government of banking supervision should insist on a clear objective (the
stability of the banking system) and on the accountability of Supervisors and the government of
banks should, for its part, be concerned with maximizing the welfare of shareholders. Delegating
the responsibilities of regulators to banks’ boards of directors, as suggested by the Basel
Committee and European Union proposals, could undermine economic efficiency, innovation
and development, and further accentuate the lack of accountability of banking supervisors and
finance ministers. Of course, the global crisis has generated a lot of distress. An efficient system
of supervision and resolution, in order to promote stability, and an efficient system of corporate
governance, in order to promote economic development and risk-taking, are therefore necessary.

Having developed an argument in favour of shareholder-based governance system, it is

important to ask whether pursuing value maximization is likely to lead to short-term objectives.
In theory, the share price should reflect the present value of the expected future cash flows. Thus,
the monitoring of share prices would be a means of assessing the expected long-term outcome of
strategic decisions. However, if due to imperfect information or market inefficiency, the price of
the shares depends on short-term results, there may be an incentive to increase the short-term
result at the expense of the long-term well-being of the company. In the banking sector, there are
many ways to improve the results presented in the short term. First, an increase in leverage
effects (borrowing/equity) can increase return on equity and earnings per share. This greater
leverage can be disguised by manipulating the risk-weighted asset measure commonly used to
assess the required level of own funds. Second, deferring the recognition of expected loan loss
provisions will improve the reported result. Third, higher credit risks can lead to a large margin
for short-term interest rates, with loan losses occurring later. Fourth, a simple maturity mismatch
(cash and carry operation in the bank portfolio recorded at historical value) at a time when the
yield curve is on the rise can show positive short-term profits, which will be followed by losses
when interest rates rise.

Although the level of foresight of financial markets remains to be proven, opacity appears to be
particularly widespread in the banking sector due to the complex nature of many transactions. In
a world where financial markets welcome short-term profits, the bank's Board of Directors has a
responsibility to be concerned with long-term value creation, even if it means harming declared
revenues and short-term stock prices. Management should conduct the business within the
regulatory framework and in accordance with strategy and behavior (ethical and cultural)
determined and supervised by the board of directors.

In a corporate governance context, how do you ensure that the members of a board of directors
fulfill their duty? Some pointed out that non-executive or independent members had been
negligent in their duties, often because of their lack of understanding of the companies for which
they were responsible. The Walker report (2009) addresses this issue with a discussion of the
family-friendly management of institutional investors. Since free riders make it unlikely that
individual investors will spend resources to exercise control, long-term institutional investors
should be relied upon to publicize their intention to exercise their government rights.

Having examined the ‘governing principles on banking supervision government’, we now turn to
a key issue of banking governance: the balance between risk avoidance and risk taking.

2.4. RISK AVOIDANCE OR RISK TAKING

It will always be possible to design a stress test, an extreme risk that brings down a bank. So is
there any indication of the level of acceptable risk? Indeed, international reports on bank
corporate governance seem to show a concern for risk avoidance, providing no indication of risk
appetite – the appropriate level of risk taking29. Conceptually, a long-term value approach should
provide guidance on the level of acceptable risk.

29
OECD Report, Richard Anderson & Associates, “Risk Management & Corporate Governance”
Long-term value creation implies that in assessing a risk decision, such as an investment in
mortgages, an acquisition or an investment in shares, the present value of expected short-and
long-term cash flows should be assessed. The probability of achieving positive outcomes, such
as mortgage repayment or liquidity available to finance an acquisition, would be assessed with
the probability of achieving less positive outcomes, such as default or loss of liquidity. In the
case of negative results, the expected additional costs resulting from reputational effects and
financial difficulties should be included30.

The concept of the cost of financial hardship needs to be clarified. In times of recession, it is
normal to have low profits and a fall in equity prices. The costs associated with the difficulties
are additional costs that arise because the company is in a difficult situation. In the banking
sector, the costs associated with financial difficulties can be considerable. First, because of the
nature of its business – short – term borrowing with long-term loans-short-term depositors could
panic and disengage. Second, undervalued shares will increase the cost of external financing
(dilution of profits if the bank issues shares at undervalued price) and prevent investments such
as acquisition. A third type of cost that arises in the event of financial difficulties could be the
need to sell assets at a discounted price in order to meet a regulatory capital ratio. Finally, and
specifically for the European Union, government subsidies for rescue lead to remedies (various
divestitures) imposed by the European Union's competition authorities.

In order to identify the expected cash flows resulting from a risky decision, it is useful to
separate reversible decisions from irreversible decisions. A reversible decision involves a risky
decision that can be reversed fairly quickly. An example would be a share or currency position
traded on liquid markets. In this case, the probability of a crisis scenario or extreme risk is likely
to be minimal over a short-term detention horizon. However, in the case of irreversible decisions,
such as holding long-term positions in illiquid credit instruments or physical investment in a
country, the probability of a large shock becomes much more important over a long-term holding
horizon.

Dermine, Jean, “Bank Corporate Governance, Beyond the Global Banking Crisis” (March 9, 2011). Available
30 30

at http://dx.doi.org/10.2139/ssrn.1781976 (last visited 25 March, 2019)

In the context of irreversible investments, it seems useful for a bank to reduce the probability of
difficulties and the resulting costs mentioned above. A first solution might be to avoid risk, but
that means missing out on value-creating activities. A second possibility is to finance the bank
with a significant volume of securities which can absorb business continuity losses (securities
involving creditors and depositors). Contingent convertible bonds and shares would be required.
This approach is feasible, but will be equally expensive. A third option is to have a diversified
activity in terms of products and geographical regions: in this way, a shock in a market can be
absorbed by the diversified group. Two examples of diversified financial groups that have so far
performed relatively well in the crisis are HSBC and Santander31. Despite significant losses in its
U.S. financial subsidiary, Household Intl, HSBC showed very good resilience during the global
crisis due to its geographic diversification in Asia and Latin America. In the case of Santander,
which was exposed to a major recession in Spain and the United Kingdom, diversification in
Latin America, the United States and Great Britain helped to maintain good results. It should be
noted that both groups have recently made acquisitions.

It is interesting to observe the oscillations of opinion among banking analysts. When the
economy is doing well and memories of the crisis fade, there is a lot of praise for the targeted
companies operating in a single market. When the economy falls into recession, praise is
reserved for diverse groups who can bear significant losses. Since a significant extreme risk
appears to occur at regular intervals, it is recommended to operate a diversified financial group.

The global economic crisis, with its impact on unemployment and public debt/GDP ratios, has of
course created anger and distress among stakeholders. As a result, several proposals on bank
corporate governance have been put forward by international organizations, such as the OECD,
the Basel Committee on Banking Supervision and the European Union.

This discussion on bank corporate governance leads to three conclusions. First, the debate on
bank governance should focus not only on their Boards of Directors, but also on banking
supervisors, with clear accountability principles. A good governance model of banking
supervision should aim at the soundness of the banking system, while an appropriate governance

31
New York Times, Dealbook, HSBC Sells U.S. Auto Finance Units to Santander, Available at
https://dealbook.nytimes.com/2010/08/31/hsbc-sells-u-s-auto-finance-units-to-santander/ (last visited 17 March,
2019)
and control by the board of directors should focus on the prosperity of the shareholders, who are
the owners of the company. As discussed earlier, a single goal will help create a more efficient
organization that needs to be concerned with its duty and loyalty towards its customers and its
relationships with employees and creditors. Second, since there are many short-term profits
maximization trends in the banking sector, boards of directors are encouraged to focus on long-
term value creation. Third, while studies of bank governance focus primarily on risk avoidance,
there is little evidence to assess an acceptable level of risk appetite. A value-based approach to
risk-taking must be taken into account the likelihood of crisis scenarios and the associated costs
resulting from financial difficulties, which are likely to be very significant in the banking sector.
In this regard, a useful distinction should be made between reversible investments and
irreversible investments, the latter being a more likely source of financial hardship. Author has
argued that risk diversification is one way to reduce the likelihood of difficulties and the costs
associated with them. This will require the creation of an organization capable of managing
complexities.
CHAPTER 3: THE SPECIFICITY OF BANKING GOVERNANCE

Corporate governance is defined as a system by which an enterprise is directed and controlled,

and it deals with the mechanisms necessary to regulate the various interests expressed within the
firm. Corporate governance contributes to a balanced relationship between the investor and the
enterprise, thereby protecting public savings, one of the main factors in the prosperity of the
enterprise.

The bank is a company. The characteristics of the banking firm are its activity, the existence of
transaction costs, the importance of risk diversification, the degree of importance of innovation
at the level of the banking sector and the regulation at the level of the structure of this sector:

 Its activity, whether in deposit or investment banking, involves the use of its capital to
secure transactions that it makes in multiple of it. The bank has a fiduciary duty to its
customers and a security duty to its shareholders, customers and the market.
 The existence of transaction costs: in the industrial analysis, Williamson32 argues that the
internalization of production activities within a firm reduces the transaction costs they
generate. We can apply this theory to the banking sector. Banks will need traditional
resources, such as buildings, computer facilities, and also intangible assets that can be
summed up as ‘knowledge capital’. The cost of this capital is accumulated over time as a
result of the long-term relationships between the bank and its customers. The existence of
these costs, as well as the cost of collecting information, therefore helps to explain the
importance of the banking firm.
 The importance of risk diversification: the more diversified the bank's services to its
clients, the wider the range of clients it will serve, the more diversified its risks. This
diversification of risks can take several forms: geographical, customers, activities.
 The importance of banking innovation in creating margin products or in attempting to
reduce risk. The trade-off is then to find a balance between innovation with more
profitable and riskier products and more traditional and less risky products.

32
Williamson, Oliver E, "The Theory of the Firm as Governance Structure: From Choice to Contract", The Journal
of Economic Perspectives 16, no. 3 (2002): 171-95. http://www.jstor.org/stable/3216956 (last visited 3 April, 2019)
  Banking regulation: in the industrial sector, the financial structure of enterprises is
governed by simple and universal rules. For banks, the regulation of their activity is
governed by several principles:
- Limit the risks of their processing activity.
- Ensure the liquidity and solvency of the banking system.
- To protect savings.

Moreover, this regulation forms part of the priority policy of the central banks and is imposed on
bank managers with, however, differences (even contradictions) from one monetary zone to
another. Banking governance thus has a dual dimension33:

3.1. AN EXTERNAL DIMENSION

Prudential Regulation, which is the set of rules designed to measure and control the risks
generated by banking activities, enables the:

 Harmonization of the conditions for the exercise of banking competition, in order to

preserve the stability and solidity of the system.
 Enhancing banking security by introducing capital adequacy and capital adequacy
standards.
 Adapting the operation of banks to market developments.

Due to the rise in banking risks, Banking supervision Standards have increased and the latest are
being implemented by the Basel Committee. Banks are required to comply with these standards
in order to guarantee their liquidity and solvency vis-à-vis their customers.

Basel I: the Cooke ratio, adopted in 1988, defines the minimum capital requirement for a bank.

Basel II: The MC Donough ratio, which succeeded the Cooke ratio, reconciles regulatory capital
with economic capital, and today Basel III rules are being put in place.

33
Marco Becht, Patrick Bolton, and Ailsa Roell, “Why Bank Governance is Different?”, Oxford Review of
Economic Policy, Volume 27, Number 3, 2011, pp. 437–463
3.2. AN INTERNAL DIMENSION

As with any other company, the predominance of a bank's governance is the chosen mode of
administration and its effectiveness. As the Board of Directors is vested with the broadest powers
to act in all circumstances in the name of the Company, within the limits of the corporate
purpose and subject to those expressly devolved to the General Meeting, it is appropriate that it
is able to:

 clearly define its mission, which must be motivated by the social interest of the
company and the interest of its shareholders by not limiting itself to the restrictive
definition of governance that Oracle White Papers provided by stipulating34:

"Corporate governance as all the provisions, institutions and rules of law designed to
prevent the crowding out of investors". The board of directors is often suggested as a
mechanism of incentive and discipline of the leaders, which should lead him to act in a
way to maximize the value of the firm”.

 Be composed of competent members who are able to challenge senior

management, because they are the ones who are accountable for the ultimate
protection of shareholders and other stakeholders and exercise their auditing and
fiduciary duties with regard to the latter.

3.3. FINANCIAL CRISIS

The number of crises has increased since the crisis of 1973. These include the debt crisis from
1982, the stock exchange shock of 1987, the EMS crisis in 1992-93, the Mexican Peso crisis in
1994-95, the Asian crisis in 1997, the Russian crisis in 1998 and the Brazilian crisis in 199935.

The current financial crisis, which is one of the most devastating, we have known, began in July
2007 in the United States.

34
ORACLE. (2009, November), “Liquidity Risk Management in Financial Services Strategies for Success”, An
Oracle White Paper, Oracle Financial Services.
35
Galbraith, J. K. (1990), “A Short History of Financial Euphoria”, New York: Penguin Books, ISBN 0-670-85028
Since2002, the United States Central Bank, which encouraged easy credit to boost the economy,
has enabled millions of modest households to become homeowners on so-called “sub-prime”
loans in 2007. Rising US rates and the collapse of the US real estate market since the beginning
have made an increasing number of borrowers insolvent. This led to the bankruptcy of some
lending institutions, whose collateral on the assets proved to be too low to prevent the assets
from depreciating. Thus, the crisis has spread from the borrower to the lender.

By the end of 2007, some major financial institutions had noticed the illiquidity of mortgage-
backed structured securities and the first cases of defaults had begun to appear. Financial
globalization and the contagion effect have caused this crisis to spread to other countries around
the world. The effect of the crisis was different in different countries. Economies that were
closely linked to the US economy had an immediate impact on their economies, credit
conditionality was tightened, and risk premiums were raised beginning in 2008. The effect was
different for emerging countries. Indeed, in recent years, some emerging economies have saved
foreign exchange from either oil revenues or their own exports. This surplus in savings has
enabled them to create sovereign wealth funds that bring capital and liquidity to the global
economy. Some emerging countries have an indirect relationship with the US economy. The
impact of this crisis was less violent and more spread over these countries36.

This crisis has emphasized:

 The weakness of regulators who are too slow to regulate international liquidity
and too timid in controlling operators (Lehman and AIG failures, for example).
 Weak governance of some banks. Crisis led to the collapse of some financial
institutions facing two crises :
- A liquidity for investment banks leading to the collapse of Bear Stearns and
most especially Lehman Brothers.
- The solvency of certain banks and mortgage institutions, whose debtors have
been in default and whose collateral assets have been depreciated.

36
James Crotty, “Structural Causes Of The Global Financial Crisis: A Critical Assessment Of The ‘New Financial
Architecture’”, Cambridge Journal of Economics 2009, 33, 563–580, Available at http/ doi:10.1093/cje/bep023 (last
visited 7 April, 2019)
For decades, the current financial crisis has been the largest and most severe one to hit financial
markets. Banks’ crises are not only the result of the external dimension of governance
(Prudential Regulation) but also of the internal dimension (Board of directors, ownership
structure, and debt). Indeed, the institutional environment, and more specifically banking
governance, plays a remarkable role in the emergence of banking crises.

These events raise questions about the limits of corporate governance and the ability of
shareholders to exercise effective oversight of management.

3.4. THE BANKING GOVERNANCE ON THE EVE OF THE CRISIS?

The banks' boards of directors have had to face unprepared, unprecedented crisis since 1929.
This crisis has challenged, at least in the moment, the canons of good governance, as pointed out
by the Nestor Advisors study "Bank Boards and the Financial Crisis", published in May 200937.

It's not because a board of directors; a) is limited in size, b) a high proportion of independents,
and c) has separate Chairman and CEO functions.

Conversely, banks criticized by the ayatollahs of governance, because their president is the
former managing director or because some directors have been in place for more than ten years,
have shown that they have anticipated the crisis better than others who easily respected the
canons of good governance (JP Morgan, BNP Paribas, HSBC). As in any development of a
specific bubble, some managers, driven by the need to present constantly rising quarterly results,
allowed themselves to take ever greater risks, as they generated immediate results.

The speculative bubble, which lit up in the autumn of 2008, had been fuelled by the excessive
development of credit operations of all kinds, made possible by the intensive use of two
mechanisms, the excessive use of which has since been extensively described and decried. :

“The securitization of the same loans which on leaving the balance sheet, gave rise to new
lending opportunities. Credit derivatives, which have, by a deviation from their purpose, let
believe that the banker no longer had to worry about the risk on his debtor since he would cover
it”.

37
David Ladipo & Stilpon Nestor, "Bank Boards and the Financial Crisis", A Corporate Governance Study Of The
25 Largest European Banks, Nestor Advisors Ltd, 2009.
In some financial groups, an objective alliance has been created, consciously or unconsciously,
between a management that could only be satisfied with ROE between 15% and 20%, which it
announced as sustainable, and investment bank teams that had found the philosopher's stone to
create GNP, thus bonus, without adding to the balance sheet and at the assumed low cost of risk.
This lasted until the day when the market handed down its sanction by bringing back into the
banks' balance sheets all the toxic assets, all the dams supposed to protect it, having been broken.
And all this to the general surprise of the majority of the boards of directors who allow to have
served the interests of the company and the shareholders by letting their establishment impose
itself massively on these new markets.

This story, told deliberately in a simplified and quick manner, raises three fundamental
questions, which underlie the entire debate on corporate governance. :

 Is there ongoing convergence between the short-term interests of certain shareholders and
the long-term interests of the corporation?
 Do the general instructions arbitrate one against the other? And if so, how?
 Have the boards of directors demonstrated sufficient independence of judgment from
their branch?

For the first question, the answer cannot be positive, because the social interest of the banks, as
some groups understood it, should have incited the directorates-general, also the boards of
directors, to analyze whether the beneficial very short-term effect of the exponential
development of certain activities on the stock exchange, was not likely to endanger solvency and
liquidity, and thus the long-term interest of the shareholders.

The second question, recent history shows us that some branches have focused on the growth of
the immediate profit, which had a beneficial effect on the stock market price and also on the
remuneration systems, while ignoring the risks taken against the long-term interest of the
shareholders or the bank.

On the third question, OECD wanted to advise all bank administrators to read the "beautiful
story of financial illusion" in which JK Galbraith 38 showed that before each explosion of a

38
The Crash of 1929 by John Kenneth Galbraith: http://www.btinternet.com/~dreklind/thecrash.htm (last visited 25
March, 2019)
speculative bubble, the gurus of the moment explained that the paradigm having changed, the old
decision-making indicators had to be abandoned, as more valid. Let us remember the internet
bubble that replaced the classic P/E ration, the glittering number of clicks or the last crisis where
specialists in credit derivatives explained that, thanks to securitization and credit derivatives, the
credit issuer no longer had to worry about the quality of the entrepreneur's signature. And we
saw how it all ended.

In view of this, some boards of directors have focused their critical analyses on the following
points:

 Had the right questions been asked about the bank's business model and did they have a
good understanding of it? Even if the council should not interfere in day-to-day
management, it must be noted that, while remaining at the global level, no bank Council
anticipated what was happening and showed a critical attitude towards managements. The
results were excellent, the profitability exceptional and the risks were supposed to be
under control; so why question the model.
 How to ensure that the board retains its ability to do so in the future by protecting its
independence and clarity. Recent history has shown that neither regulators nor academics
have seen anything coming from the crisis of 2009; the board is left alone to face this
responsibility.
 Does not the matrix organisation weaken management in its supervisory function, and
does not the increasing complexity of the products make the activities incomprehensible
to the directorate-general and the council? Is there not a risk that the increasing
sophistication of products will lead to a breakdown in the chain of understanding of
activities between specialists and managers?
 In the face of an unprecedented crisis, the boards of directors of banks or financial
institutions have come under unprecedented pressure. In a sample of 18 establishments
(excluding Italy and Spain), have changed managers in the span of 6 months, which is a
unique situation in such a short notice of time.
3.5. THE FIRST EFFECTS OF THE CRISIS ON GOVERNANCE

The first visible effects of the crisis were quite brutal:

 Half of the leaders of the major European financial institutions were disembarked during
the crisis, which only confirmed one of the recent trends in management: "Being a
successful leader is a growing state, more precarious". To convince oneself of this, one
only has to rethink the praise that the financial markets reserved for the chairman of
Royal Bank of Scotland in 2006-2007 before throwing it to the chaos in 2008. The
survivors of the crisis must remain cautious and modest; because nothing assures that the
victors of today will not be the victims of tomorrow.
 On the other hand, the dual branch structure (whether in the form of the separate
Chairman of the Chief Executive Officer or Supervisory Board and Executive Board) was
not questioned and on our sample of 18 institutions.
 Boards have been in great demand over the last 18 months (after crisis) with a significant
increase in the number of meetings, their duration and the involvement required from
each director. This was accompanied by an even stronger involvement of the audit
committees and the remuneration committees and in some cases by setting up ad hoc
committees in addition to those already in existence39.

This increased activity of boards, which are solicited on a growing variety of topics, raises some
questions:

- Have boards of directors really added value to their general management in managing
the crisis?
- How to avoid the mixing of genres between the respective roles of the board and the
general management?
- How does the council ensure that it keeps the right view of developments?
 The competence of the directors being more and more challenged by more and more
technical questions and their availability being more and more solicited then arises a clear
problem of recruitment and size of the pool. This has led to a reduction in the number of

39
Lehuede, Hector J. and Kirkpatrick, Grant and Teichmann, Dorothee, "Corporate Governance Lessons from the
Financial Crisis (May 1, 2012)”. Available at SSRN: http://dx.doi.org/10.2139/ssrn.2393978 (last visited 25 March,
2019)
 mandates held by a director in two in the US, and the opening of new profiles to boards,
with a strong background in identifying and managing risks.
 Some financial centers reacted very quickly to publish recommendations in the hope that
they would be binding on everyone. The Walker report published in spring 2009
recommends that banks be required to have a risk committee, increase the proportion of
"non-executive directors / administrators" with financial experience and improve their
knowledge of the company and their relationship with institutional shareholders and,
finally, monitor bonuses.
 Nevertheless, it should be noted that the boards of directors find it very difficult to
manage the issue of remuneration policy for managers and market operators for the
following reasons: :
- The need to protect very profitable activities and not to be robbed of its teams.
- The distortions of competition which make the Anglo-Saxon places much more
aggressive in terms of remuneration than the others, and less scrupulous in the
application of the rules limiting bonuses.

 Their involvement and awareness of their responsibility for risks lead some boards to
create new dedicated committees or to review the role and means of those already in
place (Audit), with two underlying concerns :
- It is not for the board or its committees to manage the risk control function. But,
on the other hand, it is their responsibility to determine the council's appetite for
risk and its tolerance for risk and to ensure that the organisation of risk control is
effective and appropriate.
- The multiplication of complex matrix organizations makes it more complex to
monitor risks and dilutes the responsibilities in this area. As each axis of the
Matrix sends the ball back, it is appropriate for the council to have a clear view of
who should do what.

 The boards of directors are much more involved in the form and management of
communication to shareholders. All the boards of financial institutions have had to deal
with a sharp deterioration in the brand image of the profession in general and for some of
 their own. It is questionable, in the light of some examples of failed crisis
communication, whether the council should not have invested more in the matter, perhaps
by setting up an exceptional Committee, in order to avoid such a degradation of their
reputation. This becomes a major challenge for the councils especially as the banks are
easily thrown by the policies to the popular vindicate. Since 2008, all banks and financial
institutions have been faced with a violent challenge to their image as citizens, especially
since, once they were saved from the disaster in 2008-2009, their results have recovered
violently. The boards of directors cannot ignore the fact that the public's image of the
profession has deteriorated considerably.

 The state's involvement in the life of financial institutions, which rely on its assistance,
has a visible impact on the way in which the council approaches the issue of
remuneration. The role of the remuneration committees has been brought to the fore, in a
very brutal way, because it is no longer enough to have taken an economically justified or
legally compliant decision so that it does not have damaging media effects on society. In
addition, it has become imperative to rethink pay systems in order to no longer generate
short-term bonuses based ultimately on long-term commitments and risks for the
employer. The councils can no longer accept the use of outside consultants who work for
both themselves and the branch, which can create a conflict of interest.

 In the event of state intervention, the board must ensure that the interests of this new
shareholder converge with those of the other shareholders, and also know how to manage
relations with this new partner, who may be absent from the board.

To conclude on this first part, the immediate effects of the crisis required the Boards of
Directors of the banks to ask themselves a series of key questions:

 What is the role of the board and how far should its involvement with the branch go,
particularly in terms of strategy and monitoring of risk follow-up, in order to avoid it
interfering with the branch's responsibilities?
  How can we ensure the availability, but also the competence, of its members in order to
face a greater involvement and an increasingly complex technicality?
 What role and Means for committees?
 How to make sure they were focused and avoid getting lost in the details?

3.6. THE EFFECTS IN THE LONGER TERM

 Bank administrators will be under increased pressure from shareholders and the
Company in general to see them play their role of protector of the corporate interest and
the interest of the shareholders. Too often, bank boards, especially in the Anglo-Saxon
world, have shown a less reliance on the interest of managers, by not imposing higher
standards on themselves. And so by focusing on short-term interest, they have
endangered the long-term interest of the bank.
 The board must be an active body, aware of its duty in relation to shareholders interests.

The board must have the means to carry out its tasks independently from the market pressure and
influence of management. It must be a true governing body, as the law provides, and for it to
have a real existence between shareholders and management, it is even more effective when it is
dynamic and presided over by a man, who is not a judge and party to the management, but whose
only role is to ensure Bank’s proper functioning in the service of its shareholders40.

The Weakness Of The Monist System Remains That:

- The CEO, who is first and foremost the President of the general management, is Judge and
party when he moderates the strategic debate in the board. Of course, he must defend the strategy
he proposes as director general and will have more difficulty either to challenge it or to propose
alternative options to the board. His role as director general will lead him to over-intervene in the
board (instead of in the United States, for example, there is a need for a more flexible approach
to the management of the bank).

40
OECD (2009), "The Corporate Governance Lessons from the Financial Crisis", Working Paper by Grant
Kirkpatrick, Paris, available at www.oecd.org/daf/corporateaffairs (last visited 27 March, 2019)
 The formula of the separation of functions of President and General Manager seems to
have shown a better efficiency allowing the board to be freer in relation to the general
management, even if there are several counterexamples such as RBS or UBS. The role of
the President will certainly be strengthened as a result of this crisis, as he will have to be
the guarantor of the proper functioning, independence and contribution of the board and,
as such, will have to be more accountable to shareholders for the specificity of his action.
He will also have to ensure that the board remains in its role by avoiding the temptation
of interference in management. The question remains, however, as to the exact role of the
board and the board's expectations of it, which is not yet very clear. The President's
profile is one of the guarantees of governance. A certain financial competence, but not
necessarily a purely banking competence, is essential to establish his authority vis-à-vis
the General Manager, and his recognition in the world of business must be such as to
allow him to impose himself legitimately on the directors.
 The role of the board of directors in terms of strategy cannot be left unaddressed. Is the
board only there to approve the strategy presented by the branch or should it ask for a
choice of strategies with a comparative analysis of the issues, risks and expected results?
It is believe that the Board must lead a real discussion on several strategic options and
confront the General Manager on these options before approving them; however, this is
what was lacking before the crisis, often due to a lack of awareness of the specificities of
banking and financial activity on the part of a majority of the directors.
 The Board must remain a collective body, which derives its legitimacy from this
characteristic. Its President must make sure that he does not turn into a group of
individuals, each playing its own part. If one or more of the directors does not play his or
her role, it is up to the President to intervene. But we must be aware of any move towards
a formal evaluation of the individual contribution of the directors, as this could destroy
the sense of the collective functioning.
 Hence a new question that follows from the previous one: if the role of the Board of
Directors is to be strengthened in strategic decision-making, it must be sure of the skills it
has within it. The decade that has just passed has seen governance gurus advocate the
dogma of the independence of the administrator, at the risk of bringing into boards totally
 exotic profiles, and ultimately unsuitable due to lack of competence. The crisis brings us
back to reason, because the three fundamental qualities of the administrator must be:
- Skill,
- Independence of mind and character, which does not necessarily coincide with
independence in the legal sense,
- Experience in managing complex situations.

The Boards will probably have to rethink their composition in order to allow managers to have at
their side more contributory boards and more able to challenge their proposals, and this in an
environment where it is now more difficult to recruit directors for the banks for reasons of
adequacy of competence, availability and risk apprehension. One study shows that the most
contributory and efficient directors during the banking crisis were, without context, the Chairman
of large industrial or commercial groups, and that the exclusive use of financial specialists is
reductive and poses a potential conflict of interest problem41.

It is interesting to note, however, that the appointments made to the Boards of Directors of banks
after 2009 and 2010 do not reflect a move in this direction.

- It may also involve a reduction in size to an average of 10 to 12 members with an

increase in the proportion of experienced managers. But today, the attempt at the
feminization of councils is leading to a reverse phenomenon.
- The opinion of the Nominating Committee, in the choice and selection of managers from
the internal or external, will be strengthened especially as there will be separation
between the functions of President and General Manager and that the chair of this
committee will have real stature and legitimacy. It is interesting to ask if it is not up to the
board to challenge the top management on its ability to master an increasingly complex
matrix organization
- The crisis has also shown that boards of directors, mostly composed of retired directors
(the average age of the boards of Lehman Brothers, Citigroup and Bear Stearns was
around 68 years compared to an average of 60 years for European banks) were less
responsive and less able to test the general management.

41
Stephen V. Arbogast, “Resisting Corporate Corruption: Cases In Practical Ethics From Enron Through The
Financial Crisis”, Wiley-Scrivener; 2nd edition (pg 45-50)
 - The Board of Directors and its Chairman may need to increase their own means of action.
Two lines of thought are open: why not connect the central audit and the secretariat of the
board to the President?

The time is ripe to say that the crises have had lasting effects on the functioning of the banks
boards of directors, either because they are still absorbed by the management of the banks. But,
the object of this chapter is modestly to draw some lines of reflection with a strong conviction
that it is:

- By recognizing the existence of a long-term interest which may be distinct from the
short-term interest, it will be possible to better define the role of the board of directors
vis-à-vis management. The board of directors must be able to protect the management
against external pressures aimed at seeking a sometimes absurd ROE.
- By strengthening the role of the Board and its Chairman, the Bank's General Manager
will have a legitimate and competent body to assist and control them in carrying out their
tasks, without interfering with them. It is in the board’s common sense to challenge the
famous new paradigms.
- More than the systems of governance, it is the quality of the men that counts and that this
observation should be the catalyst of the rise of the committees of the nominations, as
much in the evaluation of the performances of the managers as in the selection of the
administrators and the evaluation of the work of the board.
- Now that financial institutions must spontaneously change their governance before the
banking supervisory authorities greatly increase the regulatory shackles in this area and
that the States are trying to play a role of shareholder for which they have never shown
much concern.
- The former Glass Steagall Act formula, which aimed to separate the roles of deposit
banks and investment banks, may be one of the answers to comprehensive risk
management.

Finally, we should not fall into the usual trap, following each crisis, of believing that it is only by
increasing the size of the regulations that we can avoid past mistakes. The ENRON crisis
spawned Sarbannes Oxley, who was to avoid the derivatives of the past. This was not the case;
the famous Special Purpose Vehicles of ENRON vilipended in 2002 reappeared and prospered
from 2004 onwards. It is more through Responsibility and the balance of power that progress
will be made than through legislation.
CHAPTER 4: ENRON AND WORLDCOM FRAUD: SOME REFLECTIONS ON
CORPORATE GOVERNANCE FAILURES

Enron's bankruptcy in December 2001 was the beginning of a succession of financial scandals in
the United States, which reached their peak with the bursting of the ‘Internet Bubble’. These
scandals have involved the management teams of large listed companies in the new economy
(Enron, WorldCom, Tyco, Adelphia) as well as the large audit firms responsible for auditing
accounts and several major banks investments (Citigroup, Morgan Stanley, etc.). This series of
financial scandals unveiled, in the first place, the fraudulent management practices of business
leaders, aiming to disguise the accounts of their company to support the share price. It then
revealed the failure in the internal control system of the audit firms, which the professionals
allowed to do, if not encouraged internally, the development of these fraudulent
practices. Finally, it also highlighted the serious professional ethics violations of financial
analysts and investment banks who participated through their valuation or financial arrangements
in the manipulation of share prices and interest rates to profit directly or indirectly.

Only three months after the Enron bankruptcy, the audit firm Arthur Andersen has made the first
charge of this characteristic backlash of the Protestant ethic of American capitalism, with his
conviction in March 2002 for obstruction to justice. Propitiation of a period reminiscent of the
robber barons of the early 20th century, almost centenary company paid his disappearance, his
failures in the audit of Enron42.

Three months later, it was the turn of the US legislature to replicate with the Sarbanes Oxley Act
(SOA). Voted hastily in July 2002 by a Congress that was still in shock, this law has
strengthened the control of the accounts of listed companies, which must now be certified
personally by the president and the chief financial officer. It also imposed the creation of audit
committees composed of independent directors, strengthened the criminal sanctions against
executives guilty of fraud and created a new body of auditors (Public Company Accounting
Oversight Board), thus ending self-checking in force in the profession since its origin. Lastly, it
has given the SEC (Securities and Exchange Commission), the market regulator, more resources.

42
Peter C. Fusaro; Ross M. Miller, “What Went Wrong at Enron: Everyone's Guide to the Largest Bankruptcy in
U.S. History” John Wiley and Sons. 2002. pg. 240-45
Attention was then shifted to a few financial analysts from major brokerage firms, who became
financial stars in the 1990s. Some were accused in 2003 of skewing their valuations and of
improperly promoting debt securities to benefit their investment bank. For example, J. Grubman,
one of Salomon Smith Barney's leading analysts (Citigroup) and H. Blodget, an analyst at
Merrill Lynch, was banned from working in the securities industry for life. They had to pay fines
($ 19 million) without ever admitting their wrongs or guilt. Only F. Quatronne, investment
banker in several prestigious houses and sentenced to eighteen months in prison in May 2004,
was dismissed on Appeal.

In addition, Wall Street greats such as Mary Meker (Morgan Stanley) and Anthony Noto
(Goldman Sachs) survived the investigations of New York State Attorney General E. Spitzer.
They continue to make their career as analysts, but now with the prohibition to solicit business
for their bank and discuss transactions with their fellow bankers. The big investment banks were
not worried as such, although ten of them had to agree to pay large indemnities ($ 1.4 billion),
partly to repay victims of fraud (investors and employees).

It was not until 2006 that the lawsuits against business leaders resulted in the imposition of harsh
sentences, in the light of the hitherto on-going practices with regard to White Collar Crimes. A
dozen Enron executives have already been sentenced to prison terms of several years, although
not all judgments have yet been handed down. The heaviest penalty was imposed on J. Skilling,
Enron's former CEO, who was sentenced to 24 years and 4 months in prison. Former CEO of the
company, K. Lay, died before his trial. He was risking twenty years in prison. A. Fastow, the
former CFO, received a remission for agreeing to cooperate with the law. He was sentenced to
six years in prison but will have to complete two more years of service to the community. As for
Enron's other associates, their sentences vary from eighteen months to more than five years in
prison. Other corporate executives were also sentenced to prison: B. Ebbers, WorldCom CEO
(25 years), S. Sullivan, CFO (5 years), D. Kolowski, P -DG Tyco (between 8 and 25 years), J.
Rigas, the founder of Adelphia (15 years) and T. Rigas, its financial director (20 years)43.

However, five years after the scandals that cost thousands of employees their jobs and retirement
savings, as well as millions of dollars in losses to investors, the business community was back on

43
Vijay Prashad, “Fat Cats and Running Dogs: The Enron Stage of Capitalism”, Zed Books. 2002. Pg. 256
its feet and is mobilizing again to try to relax the new SOA regulation. An important step has
been taken with the SEC's likely easing of one of the most controversial measures in this law: the
one that requires companies to review their own accounts and ensure the veracity of their
financial reports before they deliver to the review of their auditors. It therefore appears that the
business community is preparing for a regulatory review and limiting the SEC's supervisory role
and the power of judges, making it harder for investors to sue businesses and auditors for fraud.
SOA, which imposes new responsibilities on corporate officers and directors and their auditors,
is particularly targeted. Thus, the supervisory body of the accounting profession and large audit
firms, set up by this law and which is already struggling to impose, is the subject of an attack
calling into question its Constitutional legitimacy. On the other hand, a recent report by a private
initiative committee, attributes to the binding and expensive regulation resulting from the SOA
the loss of dominant position of the United States on the capital markets, especially vis-à-vis
London. While regulatory standards are not enough to eradicate fraud and promote ethics, their
relaxation is probably not a positive signal that is conducive to restoring the confidence of
economic players and financial markets.

As of June 1999, Enron had disclosed $34 billion in property on its balance sheet, however
another $fifty one billion in property—many of which were afflicted or impaired—lay hidden in
Enron’s unconsolidated unique reason entities (SPEs). Enron engaged in similar malfeasance to
task an artificial photograph of economic resilience by way of camouflaging its total
indebtedness. At the cease of 1998, Enron had $7.37 billion in lengthy-term stability sheet debt,
but borrowing by using unconsolidated Enron SPEs accounted for another $7.6 billion in
leverage44.

Politicians and media commentators were short to argue that Enron represents a considerable
malfunction within the procedure by way of which corporations self-police and display a further.
As a result of this perceived “marketplace failure” of credit chance management, extra guidelines
on accounting, disclosure, and monetary transparency were endorsed, in addition to heightened
direct supervision of certain market contributors by way of their regulators.

44
Bratton, W.W. (2002), ‘Enron and the Dark Side of Shareholder Value’, 76 Tulane Law Review 1275.
Credit risk control is the method by means of which corporations try and display and manipulate
the potential for sudden losses arising from an obligor’s unwillingness or lack of ability to honor
all of its commitments. Despite an obvious unawareness in lots of cases of Enron’s fraudulent
sports, few firms coping with Enron regarded the enterprise as a “right” credit score threat.
Thanks to the proliferation within the beyond decade of economic merchandise and strategies
allowing firms to lessen or transfer away certain credit score exposures, many firms doing
commercial enterprise with Enron had taken full-size steps to reduce their Enron exposures
nicely earlier than news of Enron’s issues became public. This sizeable use of credit risk transfer
products additionally helped spread Enron credit score hazard fairly lightly round the worldwide
capital markets, therefore stopping a great buildup of Enron credit awareness in any single
enterprise that could have made Enron’s failure substantially more disruptive to international
economic markets than it surely changed into. Indeed, that so many companies were able to
manipulate their Enron credit exposures in spite of Enron’s misleading monetary statements
shows that the Enron debacle is a achievement tale in credit chance management, no longer a
failure. The strategies utilized by market members to manipulate their credit score risks are
reviewed right here.

4.1. THE NATURE OF CREDIT RISK

Credit risk exists only for assets. When a company owes money, services, or assets to another
firm, the insolvency of the counter party does not affect the original obligation. But when a
company is owed, the inability or unwillingness of an obligor to honor its commitments can
translate into losses. Credit risk has two components: the likelihood of default by the obligor and
the amount that will be lost if a default does occur. The latter is often called the loss given
default (LGD) or credit exposure of an asset or obligor. An important determinant of a firm’s
credit exposure is what that firm can recover from a counter party in the event of a default. For
simplicity, assume the default occurs because of insolvency. Insolvency laws in different
countries then govern the recovery process, and claimants initiate that process by filing claims
with the insolvency trustee. Secured obligations are those for which collateral has been
specifically pledged to cover any default-related losses—for example, a real estate loan that
allows the lender to repossess an underlying piece of property if the borrower fails to make a
promised payment. Assets that have been pledged as collateral must be applied to the obligations
they secure and cannot be used to honor other outstanding obligations of the defaulting firm.

The quantity a company can recover on an unsecured claim depends at the value of the
defaulting firm’s ultimate property and the concern of claimants on those belongings. Bank debt,
for example, is often senior to other obligations. The proceeds from the liquidation of the
defaulting firm’s assets thus must be used to pay off banks and other senior creditors entirely
before any lower priority claims can be honored. Junior unsecured creditors often recover only a
pro rata portion of the remaining assets of the insolvent firm after all senior claimants have been
made whole. The credit exposure on traditional assets (e.g., coupon bonds) is typically known
over the whole life of the transaction, at least to a first approximation. Contracts such as oil and
gas forwards and swaps, however, can be either assets or liabilities depending on movements in
oil and gas prices since the transaction was initiated. When a counter party to a derivatives
contract becomes insolvent or defaults on a required obligation, the contract is generally either
“accelerated and terminated” or “assigned.” In the former case, all remaining payments and/or
deliveries on the contract are accelerated to the present and marked to their current market
values. A single aggregate termination responsibility is calculated and either is due from the non-
defaulting party or becomes a standard unsecured declare of that birthday celebration at the final
belongings of the bankrupt company. If a derivatives counter celebration desires instead to
maintain its agreement in preference to accelerating and terminating it (e.g., to guarantee the
subsequent physical delivery of an asset), the original counter parties and a solvent third party
can all agree to an assignment of the old contract. The contract is first marked to its current
replacement cost (i.e., the cost of negotiating a contract with the same terms at current market
prices) and becomes either a payable or receivable of the insolvent firm. Unlike before, however,
the contract is not accelerated or terminated; all remaining delivery and payment obligations of
the insolvent firm are assigned to the new third party. Because the contract has been marked to
its replacement cost, no payment is required to effectuate such a transfer, and the contract then
runs on as before between the non-defaulting party and the new third party.
4.2. DEFAULT RISK MITIGATION

Predicting the failure of another firm is essentially impossible. Even with perfect financial
disclosure, firms are subject to uncertain and random financial market movements whose
impacts can never be perfectly anticipated. Nevertheless, tracking the monetary power of
obligors is an essential aspect of the credit score threat control manner at least to develop a few
concept of the way possibly it's far that a firm can honor all of its obligations.

Direct Monitoring Financial institutions—banks and insurance companies, in particular—

typically rely on internal systems to estimate or rank the default risks of their counter parties.
Internal rating systems encompass a wide range of methods, some of which rely almost
exclusively on the subjective judgment of credit officers and others of which rely more on
default risk models that infer default probabilities from a firm’s published financial criteria,
external ratings, industry characteristics, equity and asset volatility, and the like45. Firms with
significant credit-sensitive exposures to a given firm, moreover, often take internal monitoring
beyond a review of public information. These activities often include on-site inspections,
interviews with key personnel at the obligor, a review of internal financial and risk management
documents, and the like. Firms with significant credit-sensitive exposures to a given firm,
moreover, often take internal monitoring beyond a review of public information. These activities
often include on-site inspections, interviews with key personnel at the obligor, a review of
internal financial and risk management documents, and the like.

External Monitoring For many firms, an independent credit analysis division is a luxury that the
size and nature of their credit exposures cannot justify. Gas pipeline customers of Enron, for
example, probably did not have internal credit departments. Such firms tend to rely instead on
external monitoring to track their credit risks.

External monitoring takes place when one firm is based on the credit evaluation of a professional
credit score monitoring service for its data approximately the default hazard of its obligors. The
most outstanding external credit monitors are the rating organizations, although companies once
in a while also appearance to external auditors (e.g., resignation decisions) and regulatory

Griffith, S. (2005), ‘Good Faith Business Judgment: A Theory of Rhetoric in Corporate Law Jurisprudence’, 55
45

Duke L.J. 1.
agencies (e.g., enforcement actions) for additional credit information. External monitors
frequently use methods comparable to the internal credit risk analysis divisions of banks and
insurance companies.

Delegated Monitoring Delegated monitoring is based on the belief that banks have (or at least
had when the theory was developed) a comparative advantage in assessing the credit risk of their
customers. “A senior bank lender’s decision to roll over an unsecured revolving line of credit
thus ‘sends a signal’ of ongoing borrower creditworthiness and abrogates the need for relatively
less-informed creditors such as bondholders to undertake an independent credit assessment of
the borrower”46. This type of delegated monitoring is frequently combined with at least some
reliance on external monitoring, as well. Delegated monitoring is not only beneficial for those
firms wishing to avoid the costs of performing their own credit risk monitoring.

Exposure Limits Although the default probability of a capacity obligor can and have to be
monitored; handiest the obligor can take moves to change its default potentialities. The credit
exposure of a transaction, with the aid of assessment, can be managed by way of both party to
the transaction. One popular manner by way of which a company tries to maintain its credit score
exposure beneath a maximum tolerable loss threshold is by way of preserving a gadget of credit
score limits. For firms whose credit exposures are fantastically static and homogeneous, limits
are usually primarily based on classes or styles of counter events instead of on particular obligors
or “names” (i.e., individual organizations). A power advertising company, as an example, may
additionally specify that every one swap counter parties ought to be rated AA or above by
Standard and Poor’s (S&P). Firms whose exposures are dynamic and contain multiple financial
product kinds tend to depend as an alternative on numerical obligor-particular limits that may be
in comparison to actual estimates of credit publicity. Measures of credit score exposure on which
such limits are based range from crude approximations which includes the scale or notional
primary of a transaction to greater sophisticated ahead-looking hazard measures together with
conditional anticipated loss or credit score value-at-hazard.

Insurance In the 1980s, insurance and capital markets began to converge rapidly in the
alternative risk transfer (ART) market. Products that were once considered solely the domain of

46
Diamond, D. (1984), “Financial Intermediation and Delegated Monitoring”, The Review of Economic
Studies, 51(3), 393-414. Retrieved from http://www.jstor.org/stable/2297430 (last visited 5 April, 2019)
commercial insurance applications suddenly became popular for financial applications. One such
product of the ART revolution was credit or asset insurance. As is standard in indemnity
contracts that directly compensate a firm for actual economic damage sustained, the insurance
purchaser must have an “insurable interest” (i.e., must in fact sustain damage to justify the
reimbursement). To ensure that insurance purchasers remain vigilant in their own exposure
management practices after the insurance is in place, credit insurance usually includes a
deductible and policy limit. Credit insurance is marketed in several different forms.

The maximum standard and unconditional element is an economic warranty or an unconditional

promise by using an insurer to reimburse the safety purchaser if a loss is continued following the
incidence of a particular “triggering occasion.” Guarantees commonly define the triggering
occasion very narrowly—as an example, the financial ruin filing in a court docket by way of a
particular obligor—however otherwise comprise only a few exclusions and are payable basically
on call for besides inside the case of fraud at the a part of the insurance consumer. Credit
coverage can also be supplied via surety bonds.

The use of surety bonds to guarantee financial risks is a relatively recent by-product of the ART
revolution. Historically, surety bonds were used more to facilitate aspects of commerce such as
construction.

4.3. WHAT HAPPENED WHEN ENRON FILED FOR BANKRUPTCY?

Enron Europe’s president John Sherriff stated: “Every part of our business involved granting
and receiving credit. Really, we were in the credit business more than we were in gas or
electricity or oil47.”

Because of Enron’s diverse business profile, truly all of which had been credit score-sensitive, as
the quote shows—the credit exposures to Enron while it filed for financial ruin have been
widespread. A closer look at the case suggests, however, that most of the credit score exposures
to Enron were not with direct credit-sensitive relationships to Enron.

47
NY Times, Reed Abelson and Jonathan D. Glaterjan. 15, 2002, Enron’s Collapse: The Auditors; who’s keeping
the Accountants Accountable? https://www.nytimes.com/2002/01/15/business/enron-s-collapse-the-auditors-who-s-
keeping-the-accountants-accountable.html (last visited 2 April, 2019)
In the voluminous report drawn up by the firm Arthur Andersen on the accounts for the year
2000 of the company Enron, and published properly under the responsibility of the famous
Securities and Exchange Commission, our COB is an imitation of it, was brought to the attention
of its readers (one can assume that analysts examine this kind of document online) a clause
which, obviously, had attracted little attention. It will undoubtedly have played a decisive role in
precipitating the collapse (the biggest bankruptcy that has ever occurred in the United States) of
the giant trading in energy products (especially gas and oil, but also electricity).

Under this provision, Enron undertook in two cases to repay in advance some of the loans it had
contracted: in the event that the price of its ordinary share fell below specified levels (spread
according to the various characteristics of the debt certificates concerned between $ 28.20 and $
55) and in the event that the company was deprived of its high rating grade by rating agencies.
At the time, Enron was ranked higher (investment grade) and the title was still above $ 80. He
fell around... 0. However, by the end of the first quarter of 2000, a first and severe warning had
been issued on the growth securities market, of which Enron was a member: on the Nasdaq. But
Enron continued to look like the crown jewel, and most importantly, few professionals were
willing to believe, despite all the signals from Wall Street, that the party was coming to an end.

Even more serious: none of the analysts heard raised their voices to denounce the very dangerous
nature of such an obligation, given current market practices. This blindness is not the least
scandal raised by the Enron affair. Scandal for what such a bias reveals. The fixed idea behind all
the management decisions was to convince the market that the action "could not fall" and if, by
Chance, the price fell below 50 dollars, as it had already happened, it could only be an accident
without a future.

The sequel had to show what might have been inferred from the lightness with which the risk
had been consented. Of course, the society with super sophisticated management, based on
mathematical models ‘at all times’ of course, the Enron company, thus shielded in its feigned
certainties, was not able to keep its promise.
The risk of a default by Enron created two different types of exposures in the credit derivatives
market. The first was the risk to credit protection sellers of assuming the default risk of the Enron
name. Of the $8 billion notional in Enron-based credit derivatives rated by estimate that around
$2.7 billion notional principal was transferred to credit derivatives dealers in single-name or
small basket credit derivatives transactions. In addition, about 50 pooled credit derivatives
transactions included an Enron asset in the reference portfolio. Those transactions had a total
notional principal of around $79 billion and around $3.3 billion in replacement cost exposure.
Few credit derivatives dealers provide credit protection in that market on an unhedged basis.
When possible, dealers hedge a CDS, for example, by selling the underlying bonds short. In the
case of Enron, a protection seller could short Enron bonds against a CDS by borrowing those
bonds in a reverse repurchase agreement. These bonds are then returned to the reverse repo
counter party in exchange for funds that should be close to sufficient to cover the payment made
to the CDS counter party. In this example—as is likely to have been the case in actual practice—
the ultimate financial loss would be borne, not by the Enron credit protection buyer or the swap
dealer, but rather by the party that loaned Enron bonds to the swap dealer in the reverse repo.

“Apart from losses on credit derivatives referencing Enron as a name, a second exposure to
Enron in the credit derivatives market was borne by firms that sought protection on non-Enron
names through credit derivatives negotiated with Enron as a counter party. AICPA estimate that
Enron was the credit protection seller in at least three rated credit derivatives transactions with
a notional principal of about $3 billion total”48.

Enron itself actually had a sophisticated internal credit risk management group. In reality, Enron
determined in February 2000 to make to be had its personal transactional credit score hazard
evaluation models to other market participants—to come to be a chosen display of sorts. This
attempt gave upward push to an adjunct of Enron Online referred to as EnronCredit.Com on
which marketplace individuals may want to negotiate established credit score derivatives on-line.
In its closing years, Enron also pioneered—satirically—the imparting of “financial disaster
swaps” through EnronCredit.Com.

48
American Institute of Certified Public Accountants (AICPA). 2002. ARB 51: Consolidated Financial Statements.
Retrieved from FARS/Original Pronouncements/Committee on Accounting Procedure Accounting Research
Bulletins (ARB), Online Release
When, in November, the first bad news broke and the price began to plummet, the clause acted
as a fantastic accelerator to empty the Treasury: the creditors had to be paid immediately,
resulting in massive drawings on the apparently comfortable lines of credit that the company had
with the banks. But it was on the strength of a high stock exchange that Enron was lent without
counting. The only thing that management was still able to anticipate, without waiting for an
established insolvency, was to put the key under the door. The balance sheet was "voluntarily"
filed before the declaration of bankruptcy took place (whatever the name under which this
formality is known there).

Moreover, and this is where lies the enormous problem raised by the Enron case, but not only by
it, is that the lack of preparation to face up to any eventuality is involved in a modern and highly
complex management such as that which governed this society. The official doctrine of modern
finance, the one that had been applied in the most perfect way by the most famous hedge fund,
the LTCM (Long Term Capital Management) _ saved in extremis on a certain night of
September 1998 at a late meeting organized by Alan Greenspan (without his presence) _ is a
gamble: arrange your affairs in such a way that no solvency accident can happen except 1 day on
say 30, provided that the model, which is not the case, protects from panic, infatuation and
outbursts of all kinds.

In return for this agreed risk, but with sufficient vigilance it will be possible to postpone
indefinitely, modern financial technique gives you, whether you are a banker or a financier, the
means to maximize your profits by reducing to a minimum the assets held in the form of cash in
the proper sense of the term: type of three-month Treasury bills that yield little but are always
liquidable at little cost and without loss. This is, in a way, the just-in-time approach to finance.
At the end of the day, it implies the disappearance of the very notion of "reserves" and cash kept
in the form of cash. On the surface, it is the triumph of the "Anglo-Saxon", modern and
economically positive approach over the peasant reflex of the low wool, all of which is directed
towards the use for productive purposes of profit (or interest) of the smallest parcel of ringing
and trebuching availabilities. Pushed to its extreme limit, such a practice, elevated to the rank of
business doctrine based on the principle of maximization, amounts to relativizing all business
ethics. This relativization is not of today and, doubtless, is inherent in the innumerable trades of
exchange (where does the skill of the seller end and where does his bad faith begin?). Another
thing is, in the very principle of financial management, to admit in advance and as an integral
counterpart of the system, the existence of a risk that one puts on the others.

The implicit repudiation of business ethics by up to date management can be summed up as a de

facto relegation of the very principle of honor: the entrepreneur who expressly conforms his
management to the doctrine of Enron and LTCM, deliberately takes the risk of not honoring his
signature in all circumstances. The same is true of the distinguished chairman of Enron.

4.4. MISUSE OF CREDIT DERIVATIVES

Credit derivatives have proved to be valuable and generally dependable products. Having
become laminate since the spread of the recession and the setbacks of Wall Street and marchés
consorts, another question is again urgently raised by the debacle of one of their most beautiful,
most dynamic, Most Innovative Companies : How is it that, despite the constantly recalled
imperative of transparency, entrusted to the diligence of the best accountants and audit experts of
the world, themselves styled supervisory and regulatory bodies ; how is it that, in spite of all the
work of the accounting profession and all the arsenals of controls in charge of ensuring their
implementation on the ground, we discover so belatedly defaults often as big as a house with the
most elementary prudence, not to speak of pure and simple honesty vis-à-vis the basic saver-
investor ?

One of the reasons is that the market is not driven by accounting documents, teeming with
relevant information, drawn up by professionals almost always competent and endorsed by
public authorities. It is not he who directly influences the market throughout the year. These are
analyses that look to the future: future cash flow flows, expected returns, etc., any expectations
that will be used, or appear to be used, to determine the quoted value of the Securities and, of
course, to justify their increase, if there is an increase.

However, this information or supposed information comes mainly from the companies
themselves, in the form of press releases, periodical bulletins, quarterly accounts,
"supplemented" or "informed" by subsidiary studies on current or anticipated developments.
Surprising as it may seem, these "informal" texts are not subject to any regulation or, under the
pressure of successive scandals, are only just beginning to be regulated. This is true first of all
for the United States, but European societies are following in this direction, at high speed.
For the first time, and under the pressure created by the Enron scandal, the SEC has just attacked
the so-called pro forma accounts published by a company. The layman will hardly believe it.
Group A just performed a beautiful operation. He bought B and claims that AB is now worth
more than what the addition of A and B was worth when A and B were two separate entities.
However, analysts point out that the balance sheet comparison is not conclusive because, as a
result of the merger, the activities of the new enlarged group have changed in nature and size.

In the same way, the American companies publish during the year forecasts of so-called
operational profits: after elimination of expenses and charges known as "exceptional". They
claim that taking them into account would not make it possible to get an idea of the "true"
profitability of the company. But the so-called "exceptional" charges often come to correct the
overvalued profits of the past...

After all, the famous mergers and acquisitions make it possible to show in the accounts
something that does not normally exist there: the goodwill resulting precisely from the fact that
the company that we have just bought was worth more than we would have paid if we had
acquired each item of our assets in separate lots and deducted each item of our liabilities. That
brings us back to where we started. A large Enron type company, with a large number of
subsidiaries, is by definition a large customer. For the auditing company, for example. Hence the
suspicion, whether justified or not, that in order not to lose a large customer with a quasi-
monopoly and, consequently, irreplaceable, one will take into account his wills which have
become demands. The question becomes even more complicated when the big company pays not
only for its accounts but also for advice. The supplier may be supposed to erect a wall called "Of
China" between his two different activities; things are less clear than if the double performance
did not exist and, above all, if the customer was not one of his consolidated monsters".
CHAPTER 5: REGULATION AND SUPERVISION OF THE FINANCIAL SYSTEM

Government regulation and supervision of the financial system constitute one of the three
components of the nation's financial and monetary regime. This Chapter discusses how
government regulation and supervision evolved over time as the nation's monetary standards
shifted from commodity to representative commodity and, finally, to fiat-based standards. This
discussion is designed to explain how government emerged as a major force in the nation's
financial and monetary regime. This chapter is more focused, in two ways: First, the rationale for
government regulation and supervision is expanded to incorporate different perspective of
market failure; and, second, the important and specific types of government regulation and
supervision are outlined.

5.1. ASYMMETRIC INFORMATION, ADVERSE SELECTION AND LEMONS

The rationale for government regulation and supervision can now be extended to incorporate two
other types of market failure that interfere with the ability of the nation's financial and monetary
regime to operate smoothly. The two new perspectives of market failure are referred to as the
asymmetric information and adverse selection problems. These are general problems in any
market, and can be introduced by considering a market for a commodity such as a used car or
home. George Akerlof 49 is credited with bringing attention to how asymmetric information and
adverse selection render the used car market less inefficient. His analysis is now referred to the
"lemon problem" in the used car market. The principles, however, are general. Asymmetric
information refers to ‘the fact the buyer and the seller of the used car does not have the same
information set’. The seller generally has more information about the car than the buyer. The
seller knows the car engine burns too much oil or has a weak transmission even though the car
drives well for short distances. The buyer does not have this knowledge, and, while the buyer can
pay to have a mechanic examine the car, this is expensive and time-consuming and may not
provide reliable information if the defect is subtle. That is, the seller knows the car is a lemon but
the potential buyer does not. As a result, the potential buyer assumes the used car is of average
quality irrespective of how well it is represented and, hence, will offer a price based on that
assumption alone. If in fact the car is a lemon, the seller will be willing to accept the price based

49
Akerlof, George, "The Market for 'Lemons': Quality, Uncertainty and the Market Mechanism", Quarterly Journal
of Economics, 84: 488-500. Available at https://doi.org/10.2307/1879431 (last visited 22 March, 2019)
on average quality, but, if the car is above average quality, the seller is not likely to sell at the
average price the buyer is willing to pay. The asymmetric information problem is made worse
because of adverse selection. Adverse selection is the tendency for sellers with lemon cars to be
overrepresented in the market as they have a greater incentive to sell the car than the individual
has with a good used car. As a result, the market will be overrepresented by lemons and, because
buyers have incomplete information, buyers will be under-represented. In the context of
symmetric information there is no lemon problem, as there is no adverse selection problem. That
is to say, the more information that is available on both sides of the transaction, the more
efficient the market.

The asymmetric information problem and adverse selection are particularly important in the
financial system, because transactions are complex, reliable information is difficult to collect and
assess and financial transactions occur at a more rapid pace than most real transactions. Lemon
borrowers-that is, those with higher risk - have more incentive to borrow than those with less
risk, and, because of asymmetric information, lenders are at a disadvantage. In lending and
borrowing transactions, the asymmetric information and adverse selection problems in direct
financial markets make it difficult for small lenders and borrowers to complete a transaction.

In fact, indirect finance can be viewed as a market innovation designed to resolve the two
problems. The financial institution (including banks) offers the lender a promise to pay tailored
plans to the lender's needs but, more important, the promise to pay is liquid and with low or zero
default risk. The financial institution is able to diversify its loan portfolio to reduce risk and
devote resources to credit evaluation and monitoring, thus reducing the adverse selection
problem. This is why indirect finance is, by and large, the most important channel of finance in
developed and developing countries alike. In financial intermediation it's not important for the
lender to the financial institution to have the same information set about the borrower as the
financial institution since the institution has the incentive and resources to obtain symmetric
information. The financial institution also is able to deal with adverse selection effectively by
becoming an expert at credit evaluation50.

50Gregory Lewis, “Asymmetric Information, Adverse Selection and Online Disclosure: The Case of eBay Motors”, American
Economic Review 101 (June 2011): pg. 1535–1546
Asymmetric information and adverse selection in the direct financial markets, in contrast, cannot
be resolved by an intermediary. There is no intermediary other than a broker and agent, who
merely brings lenders and borrowers together, collects a fee for the complete transaction and has
no economic interest in the underlying promises to pay. As indirect finance was a market
innovation to resolve the asymmetric information and adverse selection problems for small
lenders and borrowers, there has been a market response to these problems in the direct financial
markets. First, small lenders and borrowers play a limited role in direct financial markets; and,
second, credit rating firms have evolved to provide information so lenders can evaluate the
creditworthiness of debt and equity issued in open markets. Credit rating information, however,
depends on a financial disclosure system for those issuing debt or equity in the direct markets.
The requirements of a transparent and meaningful financial disclosure system and the limited
role played by small lenders and borrowers in the direct markets under any circumstances
account for the fact only about 30 percent of the flow of funds in the United States is transferred
through the money and capital markets. In other countries, the role of direct markets is much
smaller.

Indirect finance and credit rating systems are market solutions to asymmetric information and
adverse selection; however, there is still a need for government regulation and supervision to
render the financial system a component of a stable financial and monetary environment.
Financial institutions have incentives to assume risk and expand credit that require some degree
of government regulation and supervision, especially in the case of depository financial
institutions. Financial markets benefit from government regulation and supervision, which
ensures a level playing field between the lender and the borrower and a meaningful financial
disclosure system in the direct money and capital markets. However, there is a fundamental
difference between the objectives of government regulation and supervision of indirect finance
and direct finance. Limiting systemic risk and maintaining a stable financial environment are the
objectives of government regulation and supervision of financial institutions. In contrast,
government regulation and supervision are not concerned with risk taking in the direct markets,
but ensuring that there is adequate information to assess risk and ensuring confidence the direct
markets are not rigged.
5.2 GOVERNMENT REGULATION AND SUPERVISION OF INDIRECT FINANCE

The institutions of indirect finance are among the most extensively regulated and supervised in
any economy because of their role in the transfer of funds from lenders to borrowers, especially
depository institutions, because their promises to pay constitute the major part of the Money-2-
Money (M-2-M) supply. The majority of funds borrowed by the private sector are from financial
institutions even though U.S. direct markets are relatively more important than in other
developed countries. Based on data from 1970 to 2000 (Hackethal and Schmidt)51, nonfinancial
businesses obtained 56 percent of their external financing from depository institutions and
nonbank financial institutions, 32 percent by issuing bonds and 11 percent by issuing equity. In
other countries the reliance on indirect finance by nonfinancial business is even higher; for
example, in Germany and Japan nonfinancial businesses obtained 86 percent of their funding
from depository institutions and non-depository institutions, 7 percent and 9 percent,
respectively, from issuing bonds and 8 percent and 5 percent, respectively, from issuing equities.
In the United States, households obtain virtually all of their borrowing from depository
institutions and finance companies, while government, at all levels, issues debt in the direct
markets. Among financial institutions, depository institutions are the most heavily regulated and
supervised, because of their role in the nation's money supply. Depository institutions are subject
to frequent on-site audits; must satisfy reserve requirements and capital-asset requirements; are
subject to asset and liability portfolio restrictions; have access to lender of last resort services;
and operate with federal deposit insurance backed by the full faith and credit of the U.S.
government. Non-depository financial institutions are also subject to a variety of similar
regulations, with the exception of deposit insurance and frequency of on-site audits. The
promises to pay issued by non-depository financial institutions do not, with the exception of
money market funds, function as money. Government regulation and supervision of indirect
finance are not confined to prudential objectives to limit systemic risk, but have other objectives
focused on the structural characteristics of the financial system in terms of numbers of firms; exit
and entry and branching; consumer protection; and industrial policies designed to provide
subsidized credit to politically important sectors of the economy. In the following we first focus

51
Schmidt, Reinhard H. and Hackethal, Andreas, “Financing Patterns: Measurement Concepts and Empirical
Results (January 2004)”, Frankfurt Dept. of Finance Working Paper. Available at SSRN:
http://dx.doi.org/10.2139/ssrn.254463 (last visited 24 March, 2019)
on the more important aspects of government regulation of depository institutions and then,
second, comment on government regulation and supervision of non-depository financial
institutions.

 RESERVE REQUIREMENTS

All federally insured depository institutions are required to satisfy reserve requirements
established and administered by the Federal Reserve irrespective of their size or whether they
operate under a federal or state charter. Reserve requirements specify the amount of funds an
institution must maintain against specific deposits52. The current reserve requirement system was
established in 1980 and can be summarized by the following questions and answers. What are
the specific deposits subject to reserve requirements? Reserve requirements apply only to net
checking or what are officially labeled net transactions accounts (demand deposits, NOW
accounts and credit union share drafts). Net transactions accounts are total accounts less amounts
due from other depository institutions. Saving and time deposits are not subject to reserve
requirements and, while reserve requirements can be imposed on large CDs and Eurodollar
deposits, the reserve requirement on these deposits was set to zero in 1990. So, for all practical
purposes, only checking deposits are subject to reserve requirements. What are the reserve
requirements? There are three rate levels (as of January 2015). First, deposits from zero to $14.5
million for an institution are exempt from reserve requirements because of the relatively small
size of any depository institution with $14.5 million or less in deposits. The ‘exemption level’ of
deposits is adjusted each year based on the past year's deposit growth. Second, deposits more
than $14.5 million up to $103.6 million are subject to a 3 percent reserve requirement. The upper
deposit level, or "low-reserve tranche", is adjusted for deposit growth in the previous year. Third,
deposits above $103.6 million are subject to a 10 percent reserve requirement.

Who sets the reserve requirements? The Federal Reserve has no independent authority to change
the first two reserve requirement levels; however, the Federal Reserve can change the third
reserve requirement from 8 percent to 14 percent. Reserve requirements have been changed only
twice since the current system was established in 1980. In 1990 the requirement for large CDs
and Eurodollar deposits was set at zero and in 1992 the requirement on transaction deposits was

52
Reserve Requirements, Investopedia, see https://www.investopedia.com/terms/r/requiredreserves.asp (last visited
12 March, 2019)
lowered from 12 percent to 10 percent. Even though the reserve requirement has not been
changed since 1992, the effective reserve requirement has declined because depository
institutions have established "retail sweep programs". Retail sweep programs shift funds from
deposits subject to the reserve requirement into deposits that are not subject to reserve
requirements. How does the depository institution satisfy the reserve requirement? Required
reserves must be held in the form of vault cash. If vault cash is insufficient to satisfy the
requirement, the balance must be held as a reserve deposit at the Federal Reserve. The depository
institution can maintain a reserve deposit either with the Federal Reserve or at another depository
institution on a "pass-through relationship". Banks that are official members of the Federal
Reserve must maintain a reserve deposit at the Federal Reserve. At one time the status of
"official member" of the Federal Reserve was important, but since 1980 the distinction between
member and nonmembers of the Federal Reserve has been economically meaningless and more a
leftover from the early days of the Federal Reserve. Do the reserve balances at the Federal
Reserve earn interest? In 2008 the Federal Reserve commenced paying interest on reserve
deposits held by depository institutions. The interest rate as of January 2015 was 25 basis points
on required reserves and 25 basis points on excess reserves. Excess reserves are total reserves
held less required reserves. The two rates are determined by the Federal Reserve and do not have
to be identical. The Federal Reserve decided to pay interest on required reserves to compensate
banks for the opportunity cost of satisfying the reserve requirement and views the payment of
interest on excess reserves as a new tool of monetary policy. Are excess reserves ‘unwanted
reserves’? The answer is a clear ‘No’. ‘Excess reserves’ is merely the technical name for reserves
above required reserves. The amount of excess reserves desired by a depository institution is
determined by economic factors and varies over time, especially with respect to changes in
interest rates. In the late 1930s the Federal Reserve made a serious policy error, because it
viewed the then high level of excess reserves held by banks as "unwanted", which could easily
be mopped up by raising reserve requirements. In fact, the high level of excess reserves was
desired. Based on this misunderstanding of the level of excess reserves, the Federal Reserve
doubled reserve requirements in a six-month period and caused a sharp recession as banks
reduced lending to reestablish desired levels of excess reserves.
  CAPITAL-ASSET REQUIREMENTS

Depository institutions are subject to a minimum capital-asset ratio. The capital-asset ratio is like
a shock absorber in your car. Like a shock absorber that softens the bumps on the road, the
amount of capital relative to assets provides a cushion to offset declines in the value of assets. A
10 percent capital-asset ratio, for example, means the value of assets can fall by any amount less
than 10 percent and the institution continues to operate with positive capital. In the absence of
government required capital-asset ratios, depository institutions would still operate with some
capital, but it would likely be far below prudent levels to enhance profit. The same can be said
for reserve requirements. In the absence of government-required reserves, depository institutions
would still operate with some reserves, but they would be far below prudent levels to enhance
profits. Depository institutions have always been subject to minimum capital-asset requirements;
however, three events have elevated the importance of these requirements and generated a more
uniform set of capital-asset requirements for depository institutions. First, in 1988, the Basel
Committee on Banking Supervision, headquartered in Basel, Switzerland, and consisting of
representatives of 12 major central banks and regulatory authorities, recommended that countries
adopt a standard set of risk based capital-asset ratios, especially for large banks with significant
international operations. The specific recommendations are known as Basel I 53 . The Basel I
capital-asset requirements are based on first computing a risk-weighted level of assets for a
specific bank. The weights are based on the credit risk of the various assets; for example, cash
and home Treasury securities are assigned a risk weight of 0; mortgage-backed securities are
assigned a risk weight of 0.2; and corporate bonds are assigned a risk weight of 1.0. Capital is
divided into tiers depending on its liquidity. The ratio of risk-adjusted assets to total capital is the
bank's risk adjusted capital-asset ratio. The recommended Basel I capital-asset requirement was 8
percent for banks engaged in significant international operations. The Basel I recommendations
were incorporated into the banking regulations of a large number of countries to varying degrees.
In 2004 and 2010 the recommended requirements were revised to correct defects in the Basel I
requirements and provide regulatory authorities with a broader range of capital adequacy
measures to better assess bank risk. The expanded requirements are known as Basel II and Basel
ill, the latter of which is still being implemented. The United States adopted the Basel I, II and III

53
Basel I, Investopedia, https://www.investopedia.com/terms/b/basell-iii.asp (last visited 12 March, 2019)
recommendations for all depository institutions above a certain size. Second, in light of the
collapse of the S&L industry in the 1980s and the $214 billion taxpayer bailout (in 2014), as well
as serious banking problems in the early 1990s, a new approach to dealing with depository
institutions was established, referred to as Prompt Corrective Action (PCA). Many countries
have adopted similar PCA policies based on the U.S. model. PCA is a policy designed to deal
with institutions well before they fail, partly based on the Basel I type of capital-asset ratio
requirements combined with a "tripwire" system of regulatory responses based on the ratio. As
the total capital-asset ratio falls, the primary regulatory authority for the depository intuition is
required to impose regulatory and supervisory pressure of increasing intensity until the final
tripwire of 2 percent or less is reached. At that point, the institution is placed into receivership, to
be closed or merged with another better-capitalized institution. Third, the financial crisis in
2008/2009 and the Great Recession raised concerns the existing capital-asset requirements
needed to be enhanced to reflect the complex portfolios of depository institutions in the new
environment of deregulation and internationalization of finance. Basel ill is currently being
implemented over the next few years and has also revised capital adequacy requirements and
established new government agencies to monitor any financial institution deemed to pose
systemic risk to the economy. There is a general consensus that depository institution capital has
been insufficient in the new environment of deregulation and financial liberalization and those
depository institutions, along with other financial institutions, need to have more skin in the
game to limit imprudent lending and investing. Hence, capital requirements are likely to continue
to be increased in the future, and regulatory authorities will be increasingly inclined to use the
capital requirements, along with other measures of financial health, as the basis for a tripwire
system of responses to changes in the health of any major part of the financial system.

5.3 THE EXPANDING ROLE OF THE FEDERAL RESERVE AS A REGULATORY

AND SUPERVISORY AGENCY

Central banks are well positioned, because of their ability to control the monetary base, to
provide lender of last resort services so as to prevent contagion and control the money supply to
achieve long-run price stability. Many argue the central bank should be concerned with goals in
addition to price stability, such as full employment, minimizing the fluctuations of actual output
around potential output and supporting the industrial policies of the government. However, this
debate is about the goals of monetary policy. There is another issue worth discussing in that,
namely: what role should the central bank play in financial regulation and supervision?

Central bankers argue they need to be an important part of the regulatory process in order to fully
appraise the performance of the financial system, to conduct lender of last resort services and to
formulate and execute monetary policy in general. There are good arguments to support this
view, but one must keep in mind that it's natural for any government agency to argue that its
powers should be expanded. The size and influence of any government regulatory agency are
valued goods and there is an inherent incentive to rationalize expanded influence. The real issue
is whether the central bank's role in financial regulation and supervision adversely impacts its
other responsibilities54.

Critics of the extensive role of the Federal Reserve in regulation and supervision emphasize the
"industry perspective" problem. Regulatory authorities tend to adopt an industry perspective
when they have a close regulatory relationship with an industry, such as the banking industry.
Tight monetary policy imposes pressures on financial institutions and markets as interest rates
increase, and may even weaken the balance sheets of financial institutions. As a result, the
central bank may become overly cautious in raising interest rates. That is, the "industry
perspective" may end up being more important for the conduct of monetary policy than the more
appropriate "public perspective". The Federal Reserve, of course, denies any such influence, but
economic theory and history suggest the "industry perspective" issue is far from trivial.

Even in the absence of an "industry perspective" problem critics of the Federal Reserve's role in
government financial regulation and supervision argue that monetary policy is taxing enough and
for the Federal Reserve to assume other responsibilities that can be handled by other entities
diverts resources from its main responsibilities - lender of last resort and price stability. The
Federal Reserve can easily obtain whatever information is needed from other agencies in
fulfilling its lender of last resort responsibilities.

As a reflection of this debate, central banks have been assigned varying degrees of regulatory
responsibilities, ranging from minimal responsibilities, such as the Bank of Japan and the Bank

54
A. Hackethal & Reinhard H. Schmidt, 2004. "Financing Patterns: Measurement Concepts and Empirical
Results," Working Paper Series: Finance and Accounting 125, Department of Finance, Goethe University Frankfurt
am Main.
of Korea, to being a major regulatory authority, such as the Federal Reserve. The Federal
Reserve is responsible for regulating banks, bank holding companies and foreign banks and for
enforcing a wide range of regulations designed to protect consumers in the financial system.
Whatever the arguments against such a role, the institutional design of the Federal Reserve is not
likely to change toward less regulatory authority.

Prudential regulation and supervision for decades focused on individual institutions and markets
designed to limit financial crisis and maintain public confidence in deposit money. This type of
regulation was intended to apply a set of rules and principles that did not vary over time; that is,
they were not to be used as an economic stabilization tool. Their goal instead was to maintain
stability in the inverted pyramid of the monetary system by limiting risk taking by individual
institutions and ensuring transparent financial markets.

As a result of the housing bubble and burst of the bubble, the financial crisis of 2008/2009 and
the Great Recession, central banks, including the Federal Reserve, have advocated an expanded
approach to regulation and supervision now referred to as macro-prudential regulation and
supervision, in contrast to the traditional micro-prudential regulation and supervision focus.
Macro-prudential regulation is a policy to be implemented not only by central banks but by all
major government regulatory and supervisory agencies working together 55 . The objective of
macro-prudential regulation is twofold: first, to identify asset bubbles, speculative excesses and
overheated financial markets; and then, second, to employ regulations over capital-asset ratios,
liquidity and margins on trading securities and place restrictions on credit underwriting.

Macro-prudential policies essentially mix the two functions of maintaining financial stability and
macroeconomic policy, which have traditionally been separate, in the sense that financial
stability regulations are not intended to vary with the business cycle while macroeconomic
policy was intended to smooth out the business cycle and limit the fluctuations of actual output
around potential output. Macro-prudential policies constitute a fundamental shift in policy that is
increasingly being discussed and it has been institutionalized through various legislations.

Financial Crisis Inquiry Commission (2011), “The Financial Crisis Inquiry Report”, Washington, D.C.: U.S.
55

Government Printing Office.

At this time it is unclear to what degree and how macro-prudential policy will become a part of
the operations of central banks and other regulatory agencies. There are some fundamental
problems with the approach, however. First, it is based on the ability of the central bank to
identify an asset bubble or some other type of speculative excess; however, central banks have an
extremely poor record in such identification. Not only did key Federal Reserve officials fail to
comprehend the housing bubble in the first few years of the new century, they continue to deny
that the central bank played any significant role in generating and supporting the housing bubble
when the evidence suggests otherwise. Second, macro-prudential policy imposes additional
responsibilities on the central bank that it is not well designed to carry out and, in the opinion of
a number of economists, not capable of carrying out. Third, central bank policy is intended to be
independent of government and the financial system; however, to extend monetary policy into
virtually every important direct and indirect channel of finance not only renders the central bank
all-powerful, but increases the interrelationships with other government agencies and the
financial system that will likely become part of monetary policy. Fourth, once central banks and
other government regulatory authorities begin to vary prudential regulations, the government has
moved into the business of allocating credit and substituting government decisions for market
decisions, in the quest for stability. The history of credit allocation policies in every country,
including the United States, should give pause to macro-prudential policy. The focus of
government regulation and supervision on non-depository institutions, as well as the financial
system in general, has expanded since the collapse of housing prices in 2006 and the 2008/2009
financial crisis. In other words, government prudential regulation now takes a more expanded
view in its efforts to limit systemic risk than previously.

5.4 CORPORATE GOVERNANCE NORMS OF DIFFERENT COUNTRIES

A. IMPACT OF THE BOARD OF DIRECTORS ON PERFORMANCE OF TUNISIAN

BANKS

While there are several other elements to governance, they are all linked to the board of
directors. In fact, the OECD defines governance as a set of relationships between a firm's board,
its shareholders and other partners. It also defines it as the structure, through which the firm's
objectives, the means of achieving them and the methods of their control are set, elements in
which the board of directors plays a vital role. This is all the more true within the banks
compared with other firms. Indeed, they are distinguished by more explicit internal and external
conflicts of interest. They need to manage higher and more diverse risks. In addition, they are in
close contact with several partners and therefore play a crucial role in any economy.

However, studies on the effectiveness of the Board of Directors as a governance mechanism for
banks in emerging markets are limited. Tunisia is one of those countries where the banking
sector is the core of the financial system. The financing of Tunisian Enterprises is mainly done
by bank loans. It is therefore important to study closely the governance of Tunisian banks, in
particular their boards of directors and their impact on their performance.

The Tunisian banking system currently has about thirty banks based around the Central Bank of
Tunisia (BCT). It comprises four categories of banks: deposit, development, business and off-
shore banks. The BCT is the currency issuing body, the Bank of banks, the State Bank, the
public service for the centralized management of foreign exchange, the agent of monetary policy
and the supervisory body of banks. In addition, it defines the prudential management rules that
financial institutions must respect. In fact, the BCT exercises Prudential Regulation based on
three standards: Solvency, Liquidity and Risk Division with a view of ensuring the solvency of
the banking system through two means; which are the treatment of the monthly accounting
position and the valuation of the bank's liabilities. Several objectives are assigned to the
prudential supervision of banks. These can be summarized in (i) ensuring that the resources
collected by banks are used to support economic and monetary policies defined by the
government; that their financial situation is sound and that they function to strengthen the
financial base of credit institutions, safeguard their prudent withdrawal; (ii) ensuring credibility
and encouraging them to adopt modern methods of risk management and assessment. There are
14 deposit banks. They receive all kind of deposits regardless of duration and form. They grant
loans mainly in the short and medium term for a period not exceeding seven years. Under certain
conditions, they may grant long-term loans from their own resources after deduction of fixed
assets, non-securities and participating interests. They can also carry out stock exchange or
foreign exchange trading as intermediaries and provide cash services for depositors and
consulting and consulting services for client companies. There are also five development banks.
Their main objective is to provide long-term financing for investment projects in priority sectors
that could not be financed from commercial resources. Whereas there are only two investment
banks. They were created in response to a apparent need for advice, assistance and financial
engineering and in general for services to facilitate the creation, development and restructuring
of enterprises. Finally, the category of offshore banks includes nine institutions. It was set up to
carry out activities specific to deposit and investment banks, mainly with non-residents56.

In addition, the financial system has undergone reforms aimed at liberalization through
deregulation, the creation of a more competitive environment among financial institutions and
the improvement of the functioning of the financial market. However, the financial system in
general, and the banking sector in particular, have not been able to get rid of the inherited
characteristics of the past, since these reforms have not completely erased the deep
characteristics of the debt economy. The banking system remains the dominant element of the
financial system. For example, the indebtedness of non-financial economic agents in 2004 was
85.19% from the financial sector (banks and other financial institutions) against 1.29% from the
capital markets57. The 2004 Annual Report of the Financial Market Council (CMF) concludes
that: "The ever decreasing pace of private bond issuance shows the marginal nature of the way
Tunisian companies finance the market .... This seems to be due to the rules of financial
transparency imposed for the use of the financial market, which are justified by the concern for
the protection of consumers”58.

Thus, these reforms have also affected the governance system of banks given their weight in the
Tunisian economy and their various characteristics. They include strong state intervention,
strong regulation and limited market discipline. Indeed, the Tunisian state's intervention in the
banking system is clear through the strong banking regulation, mainly Prudential, described
above, the fairly extensive supervision provided by the monetary authorities (BCT, FMC and
Ministry of Finance), the reforms carried out or only initiated, the restructuring and
modernization programmes and also through the holding of considerable shares of capital in
banks directly or through public institutions that it controls.

56
Abdelaziz Hakimi et al., “Universal Banking and Credit Risk: Evidence from Tunisia”, International Journal of
Economics and Financial Issues Vol. 2, No. 4, 2012, pp.496-504
57
These percentages were respectively 86.82% and 2.05% in 2003; 86.58% and 2.28% in 2002 and 81% and 2.7%
in 2002. 2000; Source: ‘Statistics/ Annual Reports’, Central Bank of Tunisia 2000 and 2004. Available at
https://www.bct.gov.tn/bct/siteprod/page.jsp?id=76&la=AN (last visited 2 April, 2019)
58
CMF is a public body responsible for the control and regulation of the financial market and also for the protection
of savings invested in securities. Available at: https://cmf.tn/?q=rapport-annuel-ann%C3%A9e-2004 (last visited 2
April, 2019)
Moreover, the Tunisian banking sector remains highly regulated and closely monitored despite
the predicted liberalization. It is governed by Bank Act No. 2001-65 of 10 July 200159. It sets out
the legal framework within which banks are to operate. In particular, it lays down rules on the
direction, administration, management and control of banks (Title III, Articles 24 to 30) and
assigns to the BCT the role of control relating principally to accounting and auditing (Title IV,
Articles 32 to 39). In order to protect depositors, the Act also established a deposit guarantee
scheme in the form of a solidarity mechanism to compensate them for the unavailability of their
deposits or other repayable funds (Articles 40 and 41). All credit institutions authorized as banks
must join this mechanism. In this way, the governor of the BCT can organize the assistance of all
credit institutions in order to take the necessary measures to protect the interests of depositors,
savers and third parties and to ensure the proper functioning of the banking system. While this is
a preventive measure against any systemic crisis, deposit insurance could have a negative impact
on the willingness of depositaries to discipline Banks. In fact, all the partners of Tunisian banks
can be self-sufficient in the extensive activities of regulatory and supervisory authorities and
reduce their efforts to discipline these banks. In addition to banking prudential regulations and
laws governing financial institutions (and more specifically credit institutions), Tunisian banks
are subject to the provisions of the new Commercial Companies Code published in 200021.
Among other things, it defines the responsibilities of the most important internal governance
mechanism, the board of directors. The latter has been amended to remove the requirement to be
a director unless the articles of association provide otherwise and except for the CEO. This may
encourage the recruitment of independent members. With regard to the separation of the
functions of Chairman and Managing Director, the choice is left to the companies that adopt the
model of the board of directors to separate or combine the two functions.

An empirical study conducted on determining the impact of the board of directors on the
performance of Tunisian commercial banks found that:

59
New Framework for The Banking System :
 The law confirms the notion of lending institutions as including banks and financial institutions and does
away with former distinction between deposit and investment banks to establish the universal bank ;
 Setting up a system to guarantee deposits in the form of a joint mechanism in which banks must participate;
 Defining the prerogatives of the internal audit permanent committee which lending institutions must set up
in compliance with the provisions of Law no. 94-25. (Legal Framework, Central Bank of Tunisia,
Available at https://www.bct.gov.tn/bct/siteprod/page.jsp?id=153&la=AN)
‘The Boards of Directors of commercial banks are quite large. They are occupied by almost as
many external as institutional directors, but a little less by foreign directors. On the other hand,
they include relatively few administrators representing the state and public institutions. In
addition, most of these banks adopt the dual functions of managing director and chairman of the
board. In addition, external and institutional directors have positive impacts on the overall
performance of the banks’60.

B. FRENCH BANKING SECTOR: A UNIVERSAL BANKING MODEL

The French banking system is characterized by the coexistence of institutions with very different
legal status. There are public institutions, non-profit institutions, as well as public limited
companies and cooperative societies. Several researchers wanted to compare the French banking
system with the banking systems of developed countries. The French banking system, compared
to the Japanese, German and American banking systems, is characterized by a double fragility of
firms and banks. Thus, it shows that over the period 1970-1987, the self-financing rate of French
firms was 39%, compared with 45% in Japan and 65% in Germany.

The French banking sector occupies an important place in the French economy with an added
value of 2.6% of gross domestic product in 2007, this value is 6.4 in 2014, this growth in activity
is mainly due to the decrease in interest rates which translates into an increase in intermediation
margins, the production of billed services is also on the rise. The number of female employees in
the banking sector in France is very high: 387,100 in 2007 compared to 371,600 in 2014. The
decrease in the number of banks is due to the new habits of the customers who go less and less to
the agency. It should be noted that the French have a banking rate that is too high at around 99%,
in 2015 with more than 72 million demat accounts and 149 million term and live accounts61.

The French banking industry was characterized during the 2000s by a large-scale restructuring,
in particular at the level of cooperative banking groups, this industry is acquiring more
opportunities than the SA banks which were after a period of crisis and internal restructuring in a
weak situation. The organizational structure of the French banking sector is particularly apparent

60
Othmani, Hidaya. "Impact of Institutional Administrators on the Financial Performance of Tunisian Banks",
Gestion 2000, vol.34, pp. 47-70.
61
This data is retrieved from National Institute of Statistics and Economic Studies, Further notes
https://www.insee.fr/fr/accueil
in the wake of the globalization, deregulation and liberalization that has affected the banking
networks of the industrialized countries; as a result, the cooperative banking groups have
strengthened their position in order to occupy an essential place in the French financial market.
However, this situation is not stable since, at the beginning of the decade, the newly competitive
banks are again at the origin of external growth operations.

A banking sector may be organized around universal banks, i.e. banks which are authorized to
carry out all banking activities, or around banks specializing in particular activities. The principle
of institutional specialization is sometimes imposed by regulation in order to avoid bank failures
related to transaction risk. This was the case in the United States, where legislation was passed in
1933 as a result of the financial crisis of 1929. It established a strict separation between
commercial banks operating as retail banks and investment banks ; however, this legislation has
been relaxed over time.

Banking groups have complete freedom to open or Close banking agencies and set them up in
geographical areas of their choice; this freedom, which was introduced in 1967, was tempered
between 1982 and 1991, but has since been fully restored. The number of permanent branches of
credit institutions at the end of 2007 was 39560 in France, resulting in a density of 0.63 branches
per 1000 inhabitants, compared with a density of 0.49 in Germany. We also observe that the
number has increased significantly since 2000; in addition, the banking groups have established
51,686 vending machines, the number of which has almost doubled in ten years.

The abolition of the Livret Bleu monopoly, which was distributed by the savings banks and La
Banque Postale, and the Livret Bleu Du Crédit Mutuel, completed this trivialization of savings
networks and products. From 1 January 2009, all French credit institutions entitled to receive
funds from the public can offer the Livret A to their customers. These measures constitute a
coherent package for the modernization of the French banking sector.

Ownership structure plays a privileged role in the empirical analysis of corporate governance.
However, it does not bear a clear-cut relationship to the strategic actions – the reliance on
external growth, especially foreign acquisitions, and the use of external finance to fund that
growth – that have played a central role in bringing about a major change in the relationship
between corporations and the financial system in France. Indeed, for some companies the
direction of causation appears to go the other way, from strategy to ownership structure. With
respect to the industrial strategies pursued by French corporations, we find a heavy reliance on
external growth, and foreign acquisitions in particular, by firms with very different ownership
structures.

Ownership structures of some of France’s most acquisitive banks in 1997 and 2002 reveal a
heterogeneous mix including state-owned enterprises like Crédit Mutuel, as well as closely held
corporations like BP and CE. Most of the banks are somewhere in between with at least one
shareholder holding more than 10%, but less than 40%, of the rights. Clearly, there is no
particular type of ownership structure that predisposes banks to pursue these types of industrial
strategy.

It is possible that it is not the industrial strategy that a bank pursues but the way it is financed that
is influenced by ownership structure. There is certainly evidence of such a link for the state-
owned enterprises that racked up large debts in funding overseas expansion in recent years.
There are echoes of similar behavior by dominant shareholders in the private sector. The cases of
LVMH and PPR suggest that closely held banks may favour a heavier reliance on debt than
equity in order to maintain their control. While these banks have issued equity to finance their
external growth, they have done so to a lesser extent than many of their counterparts. Moreover,
when they have conducted such issues, the major shareholders have participated in these issues
in proportion to their shareholdings thus maintaining their controlling stakes. However, while
this account makes some sense for these two banks, it does not seem to apply to all tightly held
corporations. It is apparent that some banks that were rather closely controlled in 1997 have
allowed their capital structure to become much more diluted since then.

C. JAPAN’S BANKING INDUSTRY: A SOCIAL EXCHANGE PERSPECTIVE ON

GOVERNANCE

The importance of the banking industry to Japan’s economy can hardly be overemphasized.
Despite the development of the equity market in Japan over the years, debt financing still
comprises more than 70% of total external sources of funds among Japanese firms in the 1990s62.

62
Aoki, M. (1994), ‘Monitoring Characteristics of the Main Bank System: An Analytical and Developmental View’,
in Aoki, M. and Patrick, H. (eds), The Japanese Main Bank System: Its Relevance for Developing and Transforming
Economies, Oxford University Press: New York, pp. 109– 143.
The importance of the banking industry to Japanese firms is not limited to a pure lender–
borrower relationship. Unlike their counterparts in the United States, which are prohibited by the
Glass–Steagall Act from holding equity stakes in other firms, Japanese banks are allowed to
maintain equity holdings of up to 5% in firms,1 a majority of which are also their clients.
Additionally, these bank equity holdings of client firms tend to be fairly stable over the years,
with the intent to foster long-term client relationships. Many authors suggest that close bank–
firm relationships lead to increased corporate governance efficiency and long-term investment
horizon among Japanese firms, which is thus widely regarded as a crucial factor leading to a
great number of Japanese firms becoming among the most competitive global firms.
Concomitantly, many Japanese banks, such as DaiIchi Kangyo Bank or Sumitomo Bank, have
also grown into giant corporations themselves, consistently ranking among the largest banks in
the world63.

The main bank system involves a highly intensive set of mutual relationships between a bank
and its clients. Main bank relationship does not have an explicit legal or regulatory basis, but is
an ‘informal set of regular practices, institutional arrangements, and behavior that constitute a
system of corporate finance and governance, especially for large industrial firms typically listed
on the stock exchange’64. Main bank relationships are not limited to those between major banks
and large firms. Almost all firms in Japan have maintained a main bank relationship and most
banks serve as the main bank in varying degree for some firms. Although some main banks have
close keiretsu relationships with their client firms, firms not explicitly affiliated with a keiretsu
such as Sony and Honda still maintain a main bank relationship.

Japan’s main bank system represents a prime example of what banking theory in the finance
literature refers to as relationship banking65, as opposed to transactional banking prevalent in
countries such as the United States or United Kingdom. While maintaining arm’s length
relationships with client firms, transactional banks provide bank loans and have very limited
involvement in client firms’ internal management. By contrast, while making ‘additional

63
Allen, F. and Gale, D. (1995), ‘A Welfare Comparison of Intermediaries and Financial Markets in Germany and
the United States’, European Economic Review, 39: 179–209.
64
Duser, J.T. (1991), ‘International Strategies of Japanese Banks: The European Perspective’, St Martin’s Press:
New York
65
Aoki, M. (1994), ‘Monitoring Characteristics of the Main Bank System: An Analytical and Developmental View’,
in Aoki, M. and Patrick, H. (eds), The Japanese Main Bank System: Its Relevance for Developing and Transforming
Economies, Oxford University Press: New York, pp. 109– 143.
financing in a class of uncontractible states in the expectation of future rents over time’,
relationship banks maintain long-term relationships with client firms, often furnishing both
equity and debt financing, sitting on the board of directors, as well as actively participating in
corporate restructuring when necessary.

Close bank–client relationship is likely to reduce the problem of information asymmetry because
main banks gather large amounts of information regarding client firms’ operations and are
familiar with the managers through stable, long-term relationships. Banks often assign directors
on client firm’s boards to enhance the quantity and quality of information about firm
management. Furthermore, main banks usually hold membership on presidents’ councils in
horizontal keiretsus, where additional firm-specific information is exchanged. Moreover, bank
involvement can mitigate the agency problem to the extent that banks are willing to bear the
costs of keeping informed about their client firms’ actions. In addition to serving as lead lenders,
main banks in Japan often hold equity stakes in the client firms. Because of their significant
stakes in the client firms, main banks have the incentive to closely monitor the borrowers’
actions. When a client firm is in financial distress, the main bank usually leads the rescue effort
and shoulders the lion’s share of the associated costs, which may avoid potential conflicts among
investors as to the best course of action. Besides, the main bank should be more knowledgeable
in implementing rescue actions owing to its intimate knowledge of the firm.

Banks in Japan usually maintain a network of close, long-term relationships with many firms.
These network relationships enable banks to monitor members’ business decisions; however, it
does not necessarily imply that banks would or could act as effective governance watchdogs all
the time. Close networks are often characterized with stable behavioral norms that prescribe or
constrain members’ actions. Member relationships are thus infused with thick elements of social
exchange that sustain ongoing relations, rather than characterized by arm’s length economic
exchange to capture immediate profits. We conceptualize Japanese banking networks as social
exchange networks, where stable social norms shape the exchange relationships among
members. As such, we contend that banks’ actions are unavoidably influenced by their social
relations with members, thereby constraining their role as governance monitors.

Based on a social exchange approach, author examines the institutional and structural properties
of banks’ relational ties that are likely to have significant impact on banks’ performance. We
emphasize both network opportunities and constraints and propose that close bank–client
networks have yielded opposite performance outcomes between the growing economy in the
1980s and the contracting economy in the 1990s in Japan66. The extant view of banks in Japan as
efficient governance monitors does not match the reality of the current financial troubles faced
by the banks themselves as well as their clients. Although the extant view correctly recognizes
the relational nature of Japan’s banking industry, it fails to capture the intricate, sticky relations
between banks and their clients in Japan, or, more generally, between long-term, close exchange
partners. Using a social exchange approach in conceptualizing banks as networks insurers who
maintain implicit contracts with their member clients, we have a better understanding of the role
of banks in Japan and the reasons why many banks in Japan are now facing financial hardship
themselves, while at the same time they have resisted pressuring their member clients to
restructure for a prolonged period of time. If we understand the social role of banks in Japan, we
would not picture them as governance monitors failing their duty. To a certain extent, it is the
banks’ unfailing commitment to its role, as network insurers, which has led them and their
member clients into the current abyss of financial distress.

Japan’s banking industry has undergone the ‘Big Bang’, a government-led deregulation plan
with intent to overhaul Japan’s financial system. The rationale behind the Big Bang is that the
risk of financial intermediation is disproportionately borne by the banks and, as such, should be
dispersed among various domestic market sectors and players, both domestic and international67.
However, the financial reforms had not led to the economic recovery that the government had
hoped for. While a major reform of Japan’s financial system is much needed to help reinvigorate
the banking industry as well as Japan’s overall economy, it is important to realize that Japan’s
business system is institutionalized with thick social structural relationships that are often
resistant to change. When a network of relations is built on historical and structural ties, the
constraints against radical, external pressure for change are often significant. This was evidenced
by the regrouping of the pre-war zaibatsu into keiretsu networks despite external force to break
up these relations. A top-down reform aimed at the financial system should be viewed as a first
step in deregulating Japan’s business system.

66
Glasgall, W. (1988), ‘The World’s Top 50 Banks: It’s Official – Japan is Way Out Front’, Business Week, June,
27: 76–77
67
Rowley, A. (1997), ‘Preparing for the Big Bang’, Banker, 147: 62–63
Compared to many other countries, Japan cannot be regarded as a highly regulated economy.
However, the intricate, implicit networks of relationships among firms may, in fact, pose higher
barriers to competition than regulation. In this regard, a higher degree of competition in the
Japanese economy should be encouraged. Moreover, the much-heralded bank-centered corporate
governance system also needs significant reform. While close bank–client relationships
contribute to tremendous growth opportunities for many firms in Japan, these relationships may
also (1) compromise banks’ incentives and ability in monitoring and controlling firm actions, (2)
lead to inappropriate strategic actions for both the banks and their client firms, as well as (3)
constrain efforts in carrying out necessary restructuring in the banks and their client firms. We
should learn from the current experience that sound corporate governance requires a combination
of internal and external mechanisms. Japan’s almost sole reliance on bank-centered governance
is a dangerous path. It is difficult to maintain efficient corporate monitoring and governance
where board members have extensive interests tied with other member firms, an external market
for corporate control is virtually non-existing, or where over dominance by one type of owner
(i.e. the bank) exists. In this regard, governance reform such as more independent directors or the
development of an active external market for corporate control would be necessary. The sole
reliance on close bank–client relationships as the dominant governance mechanism is likely to
fail.
CHAPTER 6: CONCLUSION

Naveen Kumar and J. P. Singh (2013)68 have argued that the Great Recession constituted a major
historical turning point, as it strengthens the refocusing on national approaches to achieve
financial stability. This, however, should not give us a false comforting feeling, since, as the
author has argued repeatedly in this studies, the problematic institutional characteristics that
condition the policy process remain in place:

• “The crucial importance of big banks to politicians and regulators combined

with the opportunity structures of regulators (and politicians) that incentivize
them to regard banks’ interests disproportionately;

• The unchecked simultaneous influence of national and transnational coalitions

in developing global standards;

• The unreconciled existence of national and transnational standards;

• The missing counterbalance in favour of the public good of financial stability”.

Taking these factors into account, while acknowledging the substance of national and global
reforms, it is likely that new loopholes will be created and that regulators will remain in a
position in which they won’t be able to enforce strict rules on banks. Germain69 points out that
the “final liability for major reforms lies with politicians, not regulators”. I argue that it is
because of these losers’ capacity to mobilize and the voters’ unwillingness to support such tough
choices that politicians have few incentives to initiate such reforms. ‘The next choice is always
closer than the next turmoil’ (at least in the expectations of politicians). Yet, rather than
condemning or praising the entire financial system, ‘what we should be worried about ... are the
checks and balances which encourage and discourage particular types of behavior’. In reference
of this it is very significant to study this transition at global level from three perspectives: first,
with a view to the future of global banking regulation, second to global financial governance,
and, third, to the global political economy more generally.

68
Naveen Kumar, J. P. Singh, “Global Financial Crisis: Corporate Governance Failures and Lessons”, Journal of
Finance, Accounting and Management, 4(1), 21-34, January 2013
69
Germain, R. (2001), “Global Financial Governance and the Problem of Inclusion”, Global Governance, 7(4),
411-426. Retrieved from http://www.jstor.org/stable/27800314 (last visited 5 April, 2019)
GLOBAL BANKING REGULATION AND FINANCIAL STABILITY

We began this study against the background of the recent crisis, analyzing how the governance
structures have changed because of globalization and unification of rules at international level.
This conditioning effect of the governance structure on influence and regulatory outcome is
rooted in the evolving trans-nationalization or globalization of politics and political economy.
Since the early 1970s we have witnessed an incrementally deepening level of global
institutionalization in the realm of banking regulation. The co-evolution of transnational bank
activities and banking crises on the one hand and the trans-governmental cooperation on the
other hand has established a transnational regulatory regime that enhances the interdependence
by trans-national flow of regulatory practices. Thus, author argued that if we aim to understand
or explain the recent past and the future of global financial governance, it is necessary to
synthesize several explanations of who is influential in global standard setting.

Global policy and conceptual framework should contribute to financial stability by first
anchoring inflation expectations around the central bank's price objective. In a context where the
central bank is credible, the risks of hyperinflation or deflation are ruled out a priori. The
anchoring of expectations also eliminates the sources of uncertainty that may arise from the drift
of the relative price system. Economic agents can thus save resources that would otherwise be
dedicated to covering inflation risk. Since the system of relative prices is preserved, it follows
that the objective of price stability contributes to the optimal allocation of resources in the
economy.

In this context, the emerging consensus in the central bank community is that there is no need to
worry about the evolution of asset prices beyond their information content on the future
evolution of the indices, prices specific to the productive sector and to consumption. This
doctrine, developed by the Fed, is based on two "principles": the Greenspan could, according to
which it is better not to act during the appearance of a bubble on asset prices, or financial
imbalances, but rather to act after it breaks up. The application of this principle leads to flood the
liquidity market after the bursting of a bubble or to prevent the risks of economic recession. The
second principle, formulated by Donald Kohn, Vice President of the Fed from 2006 to 2010,
states that ex ante intervention by the central bank is justified when the following three
conditions are met: (1) the central bank must be sufficiently certain that a bubble exists; (2) the
cost of bursting the bubble must be low enough (in particular, the bubble must react to small
changes in key interest rates); (3) the cost of doing nothing or acting after the bursting of the
bubble must be sufficiently high. In practice, it is considered that these three conditions are not
generally satisfied simultaneously. In addition, the example of Japan, whose central bank
triggered ten years of deflation by deciding to burst a housing bubble, has been a powerful brake
on the renewal of the experience.

The central role played by price stability leads to the principle of separation between the
monetary policy objective and the financial stability objective. This principle is reflected in
particular in the implementation of monetary policy, which is carried out in two stages: first, the
decision on interest rates is generally taken by a monetary committee on the basis of
macroeconomic, financial and cyclical information, but without taking into account the amount
of liquidity to be injected or withdrawn from the market in order to reach the level of interest
rates compatible with the objective of inflation or price stability. ; Second, central bank market
participants adjust the supply of reserves to converge the money market rate to the target rate.
This practice also leads to the principles of instrument independence (Tinbergen principle):
interest rates for price stability, management of reserves for financial stability (i.e. the money
market).

In this strategic and operational framework, there is still a justified exception to Democratic
control: the lender of last resort function, which is, however, confined to conventional doctrine
and without practical application.

In chapter 2, author has discussed about the banking supervision and its effects on the overall
performance of banks. How the strategic stability of banking system around the globe is a
necessary element for global security in today’s era. First of all, the independence of the central
banks allowed them to act quickly, taking into account past experiences and the mistakes of
monetary policy committed at the time of the Great Depression of 1929, without necessarily
having to consult or negotiate with them. The principle of central bank independence is however
well defined and inherited from the framework presented at the beginning of the article. It
focuses on a priority objective of price stability and the independence that matters is the means to
achieve it. The crisis, by its nature and its magnitude, has profoundly blurred for a time the
border between the objectives of monetary policy and financial stability. The risk of disruption
of the latter being of the first order, the second objective has undoubtedly become preponderant
in the daily action during the crisis. It is indeed difficult not to see, behind the liquidity
injections, large-scale lenders of last resort in favor of financial institutions, even of States.

At the same time, central banks have accumulated risks in their balance sheets. One of the
guarantees of their independence is their financial independence. What would happen then in
case of losses? For the moment, central banks have not been confronted with this situation.
However, they are exposed to the risk of losses on private and public securities acquired during
the crisis. Admittedly, their operations take this risk into account via appropriate haircuts. In the
case of the ECB, however, the interaction between banking risk and sovereign risk, highlighted
during the sovereign crisis in Europe, creates a potentially perilous situation: by lending to
sometimes insolvent banks, which borrow central cash against are the securities of states
themselves highly indebted, or even insolvent, not exposed to this type of risk? Moreover,
contrary to the classical doctrine, did it not continue to accept the Greek titles, which the State
failed, even if it relaxed its criteria for payment? For some observers this type of intervention
goes well beyond traditional lender-of-last-resort missions. They take the form of quasi-fiscal
operations, both ex ante if the credit risk is not sufficiently valued - they correspond to a form of
subsidies by the central bank - and ex post if losses are observed - they correspond a transfer or
form of taxes.

In chapter 3, author has talked about the specificity of banking governance. Internal and external
dimensions have been discussed here and possible effects of financial crisis on corporate
governance norms have been discussed as well. In light of this study’s insights, it is questionable
whether the detailed harmonization of regulatory standards is really the best solution to reduce
the likelihood of financial turmoil and its spreading through transnational spillovers. Finally,
there is the question of the incentives given by central banks to banks and the states and the risk
of moral hazard that result. First of all, with regard to banks, the abundant, even unlimited,
supply of liquidity at very favorable market conditions creates little incentive to come and
finance in the interbank market. The intermediation role is fully performed by the central bank
and the banks manage their liquidity passively and not necessarily responsible. The result is a
form of habituation and dependence on the abundance of liquidity that makes the conditions and
exit strategies of this type of policy difficulty.
As far as the States are concerned, one can not only question the share of the discretionary action
of the central bank, but also the nature of the 'surgery. Is it, for example, a simple bridge loan
while waiting for public money? Does this intervention aim to compensate for public failure,
budgetary errors or, in the case of Europe, the absence of resolution mechanisms at the federal
level? Whether it is the different phases of the SMP program or the announcement of the
UNWTOs (in August and September 2012), the actions undertaken by the ECB would be missed
opportunities. They would have intervened too early, prompting European governments to do
nothing at the budgetary and structural level. It is difficult to decide in the absence of
counterfactual analysis. Would not the result have been worse if the central banks, in particular
the ECB, had not intervened? Could the probable and chaotic succession of faults not have
created an unmanageable economic, social and political situation?

However, this concentration of power is not necessarily new. It recalls situations where a central
bank (such as the Banque de France, for example) carried out banking supervision functions
(with the banking Commission attached to it), conducted monetary policy (according to a
strategy of monetary targeting) and handled instruments that today would be described as
"macro-prudential" in the context of credit framework policies

Of course, the institutional and economic context has changed profoundly. Central banks were
not necessarily independent, at least in Europe; the economic context was rather that of a
relatively closed economy where it was easier to control the money supply and its counterparts:
in particular, exchange controls limited the impact of capital flows.

The growing complexity of the financial system and the many interconnections between
financial institutions are certainly an argument for centralizing all these functions within the
same institution. However, this requires a governance structure to ensure a good flow of
information between the different stakeholders, a decision-making process that limits potential
conflicts of objectives. The scheme adopted by the Bank of England is interesting in that it
allows this interaction between the various monetary, macro and micro-prudential committees,
while maintaining a certain degree of independence between these different functions.

This issue of independence is paramount. Indeed, as we have seen, the independence given to a
central bank protects the institution as a whole, even if its functions extend beyond the monetary
policy for which it was designed. It is essential in the conduct of micro-prudential supervision, as
well as in the implementation of macro-prudential measures. However, the centralization of
functions creates difficulties if errors in a new area harm the institution as a whole and affect the
effectiveness or credibility of monetary policy. Finally, it presupposes a clear and explicit
sharing of responsibilities with the other institutions and authorities (notably the budgetary
authorities).

The sharing of responsibilities is particularly complex in the European case because of the many
initiatives taken to preserve financial stability. Indeed, in the face of the sovereign debt crisis in
the euro area, a European Stability Mechanism (ESM) was created, following two temporary
financing programmes: the European Financial Stability Facility (EFSF) and the European
Financial Stabilization Mechanism (EFSM). Its purpose is to provide direct financial assistance
to states experiencing budgetary difficulties as a result of a financial crisis.

The policy framework and central bank doctrine that prevailed before the crisis was thus subject
to severe strain: it became clear not only that the objective of price stability did not guarantee
financial stability, but also that the economic and social cost of doing nothing when a financial
bubble developed is exorbitant. The policies of aggressive interest-rate cuts quickly came up
against "zero constraints," leading central banks to pursue unconventional monetary policies and
to depart largely from the explicit framework of their mandates. At the height of the crisis, the
boundary between the objectives of price and financial stability had blurred and the risk of
collapse of the financial system had become paramount. Fiscal stress in the United States or the
lack of coordination and action in Europe has finally led the central banks of these economic
zones to pursue quasi-fiscal policies.

Central banks, however, come out of the crisis. In a way that some might deem paradoxical, the
inflation targeting framework does not seem to be fundamentally challenged. Central banks are
even given new responsibilities: macro-prudential for all, which clearly introduces the objective
of financial stability and signals the need to take preventive measures to combat systemic risk
and the emergence of financial and micro-prudential imbalances for some, highlighting the need
for these central banks to better monitor the financial health of their counterparts.
The real question that arises is the capacity of central banks to carry out all these missions, both
by avoiding conflicts of objectives and interests, but above all independently. Independence is
the guarantee of the success of their fundamental missions of maintaining price stability and of
lenders of last resort.

The crisis exit strategies will be an opportunity to test this capacity very quickly: after more than
six years of crisis and abundant liquidity policies, the central banks will have to gradually
withdraw these liquidities thanks to the economic recovery, in a context in which the markets,
the banks and the states have benefited from the benefits of these particularly accommodating
monetary conditions, without having however been encouraged to make the necessary
adjustments to their balance sheets.

“The problem with detailed harmonization is that policymakers assume the dangers of
regulatory arbitrage to be minimized, while in fact rule and process layering actually increase
the number of loopholes and the potential for regulatory arbitrage. Therefore, it might be better
to refrain from harmonization, but continue or intensify supervisory coordination. This, however,
is not – at least under the current circumstances – a viable option, due to path-dependent global
opportunity structures and entrenched interests”70.

Models of corporate governance are one thing and the management is another. Just like corporate
governance norms for a regular company, norms for banks as well have so many dimensions.
One particular system does not fit for all. And therefore certain models may have better results
than the others. In chapter 5, norms of different countries have been discussed. With certain
positives and other weaknesses of different models, every model reflects certain universal
principles. In the US, the UK and Australia, the sole-board system of corporate governance
combines management and the board of directors. Germany and China utilize a model of
corporate governance that separates management Corporate Governance in banks from a
supervisory board. And France and Switzerland have a mixed board structure, which means that
firms can choose between sole and supervisory boards.

70
Steven Rosefielde and Daniel Quinn Mills, “Global Economic Turmoil and the Public Good” World Scientific,
Retrieved by https://doi.org/10.1142/9110 (last visited 2 April, 2019)
Therefore one model of board structure does not fit all users. There are wide variations in the
structures of board committees. In China, for example, the institutional investors were concerned
with achieving basic levels of board accountability and transparency. In Japan there was greater
emphasis on eliminating poison pills and anti-takeover measures. Because banks are regulated,
we cannot forget the role of bank regulators in the corporate governance process. The bank
assessments give regulators an informational advantage over stockholders and other investors. In
their role as regulators, having adequate capital and capable management are more important per
se than structure of the board. Nevertheless, regulators still have a lot of influence over who can
be a bank officer or director. One major key to success in an organization is the internal
environment.

Traditionally, the experts distinguish financial markets according to whether they are based on
the German model, focused on banks, or on the Anglo-Saxon market, which is based on equity
financing. This typology suffers from two limitations: it does not explain why a country opts for
one or the other of these models and it includes in the same category countries with very
dissimilar characteristics: can we really look at France as a German type market? Moreover, this
approach does not reveal how a system could be improved, the only practical indication being
that it must be the most efficient. The recent works on law and finance, have greatly improved
the classical approach. For example, in Law and Finance (Journal of Political Economy, 1998),
writers compiled statistics on investor protection legislation in 49 states, and combined these
figures with others on the quality of enforcement laws71. The examination of these data reveals
four main families in the field of law: the countries of common law, those of French law, those
of German law and those of Scandinavian law in civil matters. The common law countries are
the ones that best protect investors, be they shareholders or creditors, while those under French
law are the ones who protect them the worst, so that they are more favorable to the holders
information not available to third parties. This is just an example to point out how law governs
financial activities in different manner depending upon the nature of national laws and policies.

These differences between institutions largely explain the differences in financial structures. For
example, the concentration of the percentage of owners in certain age groups is negatively

71
Porta, R., Lopez‐de‐Silanes, F., Shleifer, A., & Vishny, R. (1998), “Law and Finance”, Journal of Political
Economy, 106(6), 1113-1155. doi:10.1086/250042
correlated both with the quality of the protection afforded to shareholders by the legal rules and
with the quality of the application of the rules. Investor protection is also correlated with the size
and liquidity of equity and bond markets, with financial markets being less developed where
investor protection is weakest. Certain scholars have gone further by demonstrating that legal
institutions also help explain the variation in expected return on equity in the world. Stock
returns and earnings ratios are positively correlated with the efficiency indicators of the judiciary
and the rule of law, and negatively correlated with the protection of shareholders ' rights in light
of risk and expected beneficial growth72. The increased profitability of new issues is negatively
correlated with the quality of accounting standards.

72
Joseph McCahery, Piet Moerland, Luc Renneboog, Theo Raaijmakers, “Corporate Governance Regimes:
Convergence and Diversity”, Oxford University Press, 2002 pg. 357-66
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