The relationship between corporate governance characteristics and credit risk exposure in banks: implications for financial regulation

Abstract

This article analyses board structures in listed Danish banks in the years prior to the financial crisis by exploring the relationship between corporate governance characteristics and credit risk exposure. The article presents a novel approach as it relies on a newly developed risk metric entitled the “Supervision Diamond” introduced by the Danish FSA, which “external” board directors must address. It contains five thresholds for measuring a bank’s exposure to credit risks i.e. the proportion of large customers, lending growth, the ratio of lending/deposits, liquidity buffer and the proportion of real estate loans. By employing quantitative governance variables the article finds that increased executive director remuneration is associated with increased credit risk posed by the bank’s borrowers. On the other hand, increasing the number of executive/“inside” directors is associated with a lower credit risk exposure. It is argued that more “inside” directors on the executive board constitutes a stronger “checks and balance” system. The article also documents that the probability of obtaining state capital from the Danish credit bailout package is negatively related to larger boards as well as higher executive director remuneration. The policy implication is that financial authorities should be increasingly aware of insufficient corporate governance characteristics in order to prevent excessive credit risk exposure. Moreover, the article provides important insights on which corporate governance variables have a significant impact on a bank’s credit risk exposure. This knowledge is valuable for financial authorities/policy makers considering future regulatory initiatives and how they should administer bank monitoring.