Corporate Governance and Social Responsibility in Banking and Insurance

Annotation This thesis examines the effects corporate governance and social responsibility on financial performance of banks and insurance companies.. Empirical Study of Effects of Corpo

M a s a r y k U n i v e r s i t y Faculty of Economics and Administration

Field of study: Finance

CORPORATE GOVERNANCE AND SOCIAL RESPONSIBILITY

IN BANKING AND INSURANCE

Diploma Thesis

Brno, 2016

Annotation

This thesis examines the effects corporate governance and social responsibility on financial performance of banks and insurance companies For this purpose, we have conducted econometric analysis of panel data and employed four different measures of financial performance, namely, Tobin’s Q, Market Capitalization to Book Value, Return on Common Equity (ROE) and Return on Assets (ROA) The thesis is divided into three chapters First two chapters provide introduction to the concepts of corporate governance and corporate social responsibility and discuss existing literature with respect to their impact in financial institutions The last chapter introduces the dataset, methodology used to estimate relations under consideration and discusses corresponding empirical results Our findings indicate that corporate governance and social responsibility factors significantly influence financial performance in both sectors Furthermore, we document that market performance and accounting-based profitability measures are affected by relatively different sets of indicators Some of the most prominent factors include: board independence, frequency of board meetings and United Nations (UN) Global Compact signatory

Keywords

Corporate governance, corporate social responsibility (CSR), econometric analysis, financial performance

Brno, 13.05.2016

Author’s signature

CONTENTS

Introduction 8

1 Corporate Governance 10

1.1 Definition and importance 10

1.2 Principles of corporate governance and institutional recommendations 14

1.3 Changes in corporate governance in regard to the global financial crisis 17

1.4 Empirical evidence on the effects of corporate governance on bank performance 19

1.5 Empirical evidence on the effects of corporate governance on insurance companies’ performance 23

2 Corporate Social Responsibility 26

2.1 Definition and importance 26

2.2 Empirical evidence on the effects of CSR on financial institutions’ performance 27

3 Empirical Study of Effects of Corporate Governance and Corporate Social Responsibility on Financial Institutions’ Performance 32

3.1 Data 32

3.2 Methodology 41

3.3 Empirical results 44

3.3.1 Banks 44

3.3.2 Insurance companies 55

Conclusion 63

References 65

List of Tables 75

List of Figures 76

List of Abbreviations 77

List of Appendices 78

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INTRODUCTION

Sound functioning of financial system is an essential factor for country’s economic development Banks and insurance companies are some of the major members of the system, therefore, their effective and efficient performance can directly or indirectly affect lives of many As an example, ramifications of recent financial crisis included reduced private or government investments in different fields, as well as increased unemployment, which in long-rung may decrease level of labor force supply (Appelbaum, 2012)

Excessive risk-taking by banks is deemed to be one of the dominant reasons causing meltdown

of financial markets (Peni & Vähämaa, 2011) This could be controlled via corporate governance mechanisms, as they are meant to deal with principal-agent issues, such as misbehavior of management that threatens welfare of shareholders and other stakeholders (Gup, 2007) Importance of corporate governance increases in cases of agency problem and high transaction costs to create comprehensive contracts as a solution (Hart, 1995) Since both of the conditions are present in banks and insurance companies, it’s not surprising that particular researchers connect results of crisis to shortcomings in existing corporate governance practices and regulation (Cheng, Hong and Scheinkman 2010; Ellul and Yerramilli 2013; Keys et al 2009).1 Some of the documented examples of weak corporate governance procedures include: activity, rather than enterprise-based risk management, uninformed boards and senior management about risk exposures, failure of boards to establish suitable metrics to monitor implementation of approved strategy and misalignment of remuneration systems with the long-term interests of the company (OECD Steering Group on Corporate Governance, 2009) New Basel III standards, issued in response to 2008 financial distress may enhance corporate governance by limiting risky decision-making and providing increased transparency for investors (Howard, 2014) Based on the thorough analysis of corporate governance procedures failures during the crisis, Organisation for Economic Co-operation and Development (OECD)

as well as Basel Committee on Banking Supervision (BCBS) have published revisions of recommended principles, thus, placing special emphases on importance of corporate governance for stability of financial systems (OECD, 2010; BCBS, 2010)

Apart from the fact that good corporate governance is believed to be helpful in strengthening firms’ ability to resist unfavorable externalities (Greuning & Brajovic-Bratanovic, 2009), in literature it is also associated with better financial performance (e.g Peni and Vähämaa, 2012; Caprio, Laeven, and Levine, 2007; Cornett, McNutt, and Tehranian, 2009) However, empirical evidence is not entirely straightforward with respect to every aspect of corporate governance practices

Corporate governance is closely related to the concept of corporate social responsibility (Louche & Van den Berghe, 2005) Despite longevity of discussion in management literature regarding corporate social responsibility (CSR) and related concepts, such as corporate social performance (CSP), corporate social responsiveness or corporate citizenship, the domain still remains “controversial, fluid, ambiguous and difficult to research” (Wood, 2010, p 50) In light

of recent financial crisis, engagement in socially responsible behavior can be viewed as compensation from financial institutions for receiving public resources instead of raising capital from shareholders (Shen, Wu, Chen, & Fang, 2016)

Similarly to corporate governance studies, scholars have been interested in investigating association between CSR and various aspects of performance (e.g Soana, 2011; Jo, Kim and

1 Cited according to Laeven, Luc 2013 Corporate Governance: What’s Special About Banks? Annual Review

of Financial Economics, 5, 63-92 Available at:

http://www.annualreviews.org/doi/abs/10.1146/annurev-financial-021113-074421

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Park, 2015; Simpson and Kohers, 2002) Although, due to diverse underlying motives of engagement in CSR, usage of different methods, measures, model specifications, industries or time periods, evidence regarding the question under consideration has been mixed and contradictory

The aim of this thesis is to investigate impact of corporate governance and social responsibility

on financial performance of listed European banks and insurance companies For this purpose,

we conduct econometric analysis of panel data based on a sample of 98 banks and 40 insurance companies across Europe In quantifying financial performance, we follow existing literature and employ Tobin’s Q and Market Capitalization to Book Value as proxies of market performance, while Return on Common Equity (ROE) and Return on Assets (ROA) are used

to measure companies’ accounting-based profitability

Our study extends earlier research on the relationship between corporate governance and CSR and financial performance by examining practically identical sets of factors in banking and insurance sectors separately Furthermore, unlike previous investigations, we study CSR and corporate governance indicators simultaneously, and finally, we retrieve data from the Bloomberg, thus involving all the available and relevant measures of Environmental, Social, and Governance (ESG) factors

The remainder of this thesis is organized as follows: Chapter 1 provides introduction to the concept of corporate governance, explores international principles and recommendations in response to recent financial crisis and provides insight of existing literature in this regard Chapter 2 presents review of the literature on corporate social responsibility and its impact on financial performance Chapter 3 introduces the data, methodology used to estimate relations under consideration and discusses corresponding empirical results

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1.1 Definition and importance

Before proceeding to the ultimate goal of the thesis to determine relationship between corporate governance and financial performance, this section briefly reviews existed definitions and treatments towards the concept itself In some cases, issues addressed by corporate governance have been mainly associated with principal-agent problem (Gup, 2007) A principal-agent problem arises when there is a need to create optimal contract between two parties, where one party (agent) is offered a contract to perform certain tasks on the other’s behalf and thus is able

to influence outcomes of the process The group of investors and their portfolio managers or the owners of the companies and their managers and chief executive officers (CEOs) are some examples of who can be treated as principals and agents (Cvitanić & Zhang, 2013) The root of the problem is information asymmetry, which allows agents to behave in their own interest, against principles’ expectations (Venuti & Alfiero, 2016)

Even though there are similarities in understanding the idea of corporate governance, exact definitions vary and depend on the regions, models, authors or the purpose of the research For example, while studying history of corporate governance development in different countries Morck and Steier (2005) address the concept as decisions about capital allocation across and within firms

In a broad way “corporate governance can be considered as an environment of trust, ethics, moral values and confidence – as a synergic effort of all the constituents of society – that is the stakeholders, including government; the general public etc.; professional/service providers – and the corporate sector” (Crowther & Aras, 2009, p 26) At the same time “Corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined” (Organisation for Economic Co-operation and Development, 2004, p 11) In other cases, concept is described into more details and main emphasis is put on accountability: “It can include a range of activities, such as setting business strategies and objectives, determining risk appetite, establishing culture and values, developing internal policies, and monitoring performance Corporate fairness, transparency, and accountability commonly are viewed as goals of corporate governance” (Federal Deposit Insurance Corporation, 2005, para 2)

Constituents of corporate governance in banking include managing operations in accordance with legislation, specified risk profile and interests of stakeholders (Greuning & Brajovic-Bratanovic, 2009)

Gup (2007) distinguishes two different models of corporate governance in banks: The American and Franco-German In Anglo-American model, main concern of corporate governance is “how to assure financiers that they get a return on their financial investment” and thus “deals with the agency problem: the separation of management and finance” (Shleifer & Vishny, 1997, p 773); whereas Franco-German model is characterized with relatively high concentration of ownership and takes into account the interests of not only shareholders but also stakeholders (Gup, 2007) Besides, unless presence of specific legal requirements, in Anglo-American model, management is expected to make decision in favor of shareholders whenever shareholder value maximization interests conflicts with any other interested parties (Macey & O’Hara, 2003) A relatively simple and organized comparison of these two prevailing models are presented by Baran (2008) which we provide in Table 1

Anglo-11

Since our sample of the companies mostly consist of the firms from continental Europe, German model of corporate governance is of particular interest As evident in Table 1, main features of continental system are two-level board structure, consisting of executive and supervisory board, concentration of ownership with strong representation of banks and counting

Franco-on bank credits rather than financial markets for raising additiFranco-onal capital

Implications of good corporate governance are studied in different aspects, although, generally

it is believed to help companies avoid adverse situations, create economic value and ultimately

“underpin investor confidence in a market and trust in individual company management” (Edkins, 2012, p 14)

Table 1 – Comparison of corporate governance systems

representation of the political sphere undesirable indirect

links of the bank and industrial capital inadmissible very narrow

Source: Baran, 2008, p 419

Effective and sound functioning of banking system is vital for economic development of a country Importance of the banks’ robust performance increases in those countries where main sources of obtaining funds to finance companies’ activities are financial intermediaries rather than financial markets; or if banks can play significant role not only through direct possession

of stocks, but via subsidiary investment funds or management of depositary proxy rights For instance, in 1992 in Germany voting rights exercised by banks in general shareholder meetings

of 24 largest widely held stock corporations on average amounted to 84.09% (Aluchna, 2009) According to Hart (1995), importance of corporate governance increases in cases of agency problem and high transaction costs of creating comprehensive contracts in order to solve the abovementioned problem Author discusses several mechanisms which can constrain managers’ activities driven by own interest, such as monitor held by boards of directors or large

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shareholders, as well as threat of proxy fights, hostile takeovers and relinquished positions in case of inability to pay debts that company faces

More generally, de Haan & Vlahu (2015) outline following mechanisms that might be utilized

by investors to reduce agency problems:

1 The size and composition of the board ─ boards of directors are appointed by shareholders By means of advising and monitoring management they are expected to protect shareholders’ interests Boards in banks are reported to be bigger than in firms from other spheres that could be explained by relatively larger volume of assets managed or complexity of organizational structure As for composition, inclusion of independent directors is justified by their potential of being more effective in controlling the management.2

2 Concentrated ownership ─ the reason why concentrated ownership could be used for controlling management is existence of free riding problem in companies with scattered shareholders Whereas large shareholders are expected to have better informational background which they should use in favor of all the shareholders However, empirical evidence regarding the subject is diversified As for distribution of bank ownership

across the world, according to Caprio et al (2007), in three forth of the cases banks are

not widely held, although results are different on country level

3 Management compensation schemes ─ compensation schemes are used to incentivize managers to maximize shareholder value However, it’s necessary to align management’s interest to company’s long-term performance, otherwise the scheme can promote excessive risk-taking if payment depends largely on company’s short-term performance

4 The market for corporate control ─ proxy contests, friendly mergers and takeovers, and hostile takeovers are ways of market corporate control, the latter perceived as the most effective in ensuring that management’s behavior is in line with shareholders’ interests Empirical evidence on its effectiveness though varies according to a time frame and differs depending on year of study publication In particular, M&A (Mergers and Acquisitions) performance studies published before and after 2000 have different consensus about the issue (DeYoung, Evanoff, & Molyneux, 2009)

Corporate governance practices applied in particular bank can be deemed as one of the main factors influencing bank’s sound performance Even though banks might be perceived as ordinary firms, Levine (2004) marks out two specific characteristics of them which motivates independent analysis of governance in banks: relative opacity in comparison with other nonfinancial companies and often heavy regulation of the sector by governments He states that these characteristics have particular implications against common corporate governance mechanisms First of all, higher degree of information asymmetry lowers the possibility of interested parties like debt/equity holders to control bank managers’ activities Furthermore, it complicates formulation of contracts that would ensure conformity of managers’ behavior with shareholders’ interests and finally decreases effectiveness of hostile takeovers and competitive product markets as corporate governance mechanisms As for another characteristic, based on the research of 107 countries, Barth, Caprio, Levine (2004) find that majority of them

2 As opposed to agency theory, the stewardship theory suggests that due to better understanding of the business

and absence of agency costs, significant participation of inside directors on the board should lead to more effective and efficient decision-making process (Tannaa, Pasiouras, & Nnadi, 2011)

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(approximately 73%) restrain concentration of bank ownership into single entity.3 Besides, Levine (2004) marks out that governments often impede competition in banking sector through regulating range of activities allowed to banks to engage, imposing portfolio restrictions, liquidity requirements or even limits on interest rates This type of regulation hinders usage of common corporate governance mechanisms, such as equity concentration and competition

In addition to the abovementioned characteristics, Laeven (2013) emphasizes following aspects that differentiate banks from other nonfinancial companies: presence of high leverage, diffuse debtholders (depositors), relatively long-term assets in comparison to liabilities and their representation as large creditors High leverage has special implication in combination with opacity of assets These factors create possibilities as well as incentives to take excessive risk and thus increase “financial fragility” However, the main determinant of banks’ distinctness is deposit insurance and regulation since they influence utilization of the traditional corporate governance mechanisms While deposit insurance demotivates depositors to monitor banks’ performance, restrictive regulations may weaken “effectiveness of the market for corporate control” (p 68)

Listed differences of corporate governance in banking leads to separate and independent analysis of application of corporate governance mechanisms Besides, in order to provide sound financial system and protect it from excessive risk-taking from banks, Laeven (2013) argues that it’s not enough to focus just on individual bank’s compliance with corporate governance standards and it’s necessary to improve corporate governance and regulation simultaneously,

in combination and coherently

Insurance companies also have industry specific characteristics, some of which even distinguishes them from other financial institutions Venuti and Alfiero (2016) outline the following industry specific traits that influence application of corporate governance mechanisms in insurance companies:

 Strict regulation of the sector regarding solvency as well as pricing, provided by different regulators leading to relative heterogeneity in legislation

 Inversion of production cycle as long as raising revenue in the form of premiums precede the time when corresponding costs are incurred

 Another peculiarity regarding revenues/costs generation is related to certainty of the former in terms of amount and time and uncertainty of the latter until policy expires

 High level of “social relevance” and importance for the community, policyholders and financial markets due to their role as institutional investors

All the mentioned characteristics underscore the importance of risk management in insurance companies and therefore need to apply correct corporate governance practices in order to address existent and potential risks Furthermore, purposes of good corporate governance practices are not limited to protection against different types of risks and include supporting company success by making it more attractive to investors and highly qualified professionals (Njegomir & Tepavac, 2014)

While describing general approaches and ways of thinking towards corporate governance in banking and insurance, we would like to emphasize that the aim of this thesis is to measure

3 Cited according to Levine, Ross 2004 The Corporate Governance of Banks - a concise discussion of concepts and evidence Policy, Research working paper; no WPS 3404 Washington, DC: World Bank Available at: http://documents.worldbank.org/curated/en/2004/09/5168087/corporate-governance-banks-concise-discussion- concepts-evidence

First of all, we should discuss OECD Principles of Corporate Governance formulated in order

to assist governments, corporations, investors and other participants in developing good corporate governance The document published in 2004 represents a baseline and provides general understanding of corporate governance framework While acknowledging the fact that single universal model of good corporate governance doesn’t exist, based on common features

of different models OECD (2004) presents 6 broad principles, which are further explained and supplemented by annotations, particular examples and methods of implementation Below we provide abovementioned principles and short comments about their rationale:

I Ensuring the Basis for an Effective Corporate Governance Framework – “The

corporate governance framework should promote transparent and efficient markets,

be consistent with the rule of law and clearly articulate the division of responsibilities among different supervisory, regulatory and enforcement authorities” (p 29) – while developed by taking into account overall impact of the framework on economic performance, system should be reliable for all market participants, at the same time remaining open for changes and adjustments in accordance with new business experiences

II The Rights of Shareholders and Key Ownership Functions – “The corporate

governance framework should protect and facilitate the exercise of shareholders’ rights” (p 32) – section discloses most basic rights of shareholders, such as voting and participation in general shareholder meetings, election and removal of board members and so on Those rights, according to the report are recognized by basically all OECD countries

III The Equitable Treatment of Shareholders – “The corporate governance framework

should ensure the equitable treatment of all shareholders, including minority and foreign shareholders All shareholders should have the opportunity to obtain effective redress for violation of their rights” (p 40) – The goal of the principle is

to protect investors for instance, by utilizing ex-ante and ex-post shareholder rights

More specific example might be the ability “to initiate legal and administrative proceedings against management and board members”, although the risk of litigation abuse rises the need of striking a balance between the two

IV The Role of Stakeholders in Corporate Governance – “The corporate governance

framework should recognise the rights of stakeholders established by law or through mutual agreements and encourage active co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises” (p 46) – since the stakeholders of the company, such as for example

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investors, employees, creditors, and suppliers are also considerable resource providers to overall success of the firm, the governance framework is encouraged to recognize the benefits of serving stakeholders’ interests

V Disclosure and Transparency – “The corporate governance framework should

ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company” (p 49) – Promotion of transparency is a core quality

of the corporate governance framework because of many reasons Firstly, it ensures availability of market-based monitoring and shareholders’ right to be informed before making decisions Besides, lack of accurate and valuable information may lead to increase in cost of capital, inefficient allocation of resources and ultimately, improper functioning of markets

VI The Responsibilities of the Board – “The corporate governance framework should

ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders” (p 58) – Boards are also expected to act in the best interests of shareholders, ensure adequate return for them, deal with stakeholders and exercise objective and independent judgement while fulfilling their duties

Given the importance of banking industry, in 1999 the Basel Committee on Banking Supervision (BCBS) published guidance with an intention to “assist banking supervisors in promoting the adoption of sound corporate governance practices by banking organisations in their countries” (Bank for International Settlements, 2006, para 1) Furthermore, BCBS issued revised version of the document in 2006 Due to corporate governance failures witnessed during

the financial crisis, the Basel Committee published Principles for enhancing corporate governance (2010) where best practices for banking organisations are documented and strongly

recommended The final version of aforementioned document, dated by July 2015 establishes

13 principles based on more general background provided by OECD (2004) The aforementioned principles address issues related to board and risk into more details, namely through three principles for each Since board’s responsibilities, composition and structure is also discussed in OECD principles above, here we focus on risk management, monitoring and controlling Distinguishing quality of the Basel Committee principles is to prescribe risk management functions and responsibilities of chief risk officer (CRO) or equivalent (Basel Committee on Banking Supervision, 2015) For the effective execution of his/her function, it’s important for CRO to have sufficient authority, expertise and access to the board Besides, duties related to position should not be connected to the executive functions in order to avoid conflict of interest To facilitate risk identification and subsequent actions, BCBS issued

Principles for effective risk data aggregation and risk reporting in January 2013, required for

global systemically important banks (G-SIBs) to be implemented by 2016 Important tools for addressing and mitigating risk are stress tests and scenario analyses, which are additionally

discussed in Principles for sound stress testing practices and supervision (2009) Finally, strong

risk culture, that implies ongoing robust communication about risk issues horizontally as well

as vertically, is a key quality of an effective risk governance framework Other areas, covered

by BCBS include senior management, internal audit, compensation, governance of group structures, management of compliance risk, disclosure and transparency and the role of supervisors

Next we discuss general approaches, regulatory framework and monitoring in large European countries, such as the UK, France, Germany, Netherlands, Italy and Spain Review is based on

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the Corporate Governance Guide for Main Market and AIM Companies (2012) published on

London Stock Exchange web site.4 As described below, mentioned states provide their own governance frameworks, while all applying the ‘comply or explain’ principle, which implies that companies should either adopt the suggestions contained by relevant code (and report about it), or explain the reasons of non-compliance The exception is Italy, which introduces the

regime only in case of adoption of the Italian Corporate Governance Code The

abovementioned approach gives the boards opportunities to make judgements on a case basis and therefore achieve good corporate governance by means that take into account individual company characteristics, such as for example culture, size, complexity and nature of imposed risks (Murphy & Cronin, 2012)

case-by-The UK Corporate Governance Code (formerly the Combined Code) is a set of standards of

good practice regarding board leadership and effectiveness, remuneration, accountability and relations with shareholders (Financial Reporting Council, 2014) All companies with a Premium Listing of equity shares in the UK are required to report on how they have applied the main principles of the Code in their annual report and accounts For each determined area the Code provides Main Principles, Supporting Principles and Code provisions A Leadership section underscores the chairman’s responsibility as a leader of the board, which is on its own part, responsible for long-term success of the company Necessity of the board and its committees to be balanced taking into account skills, experience, independence and knowledge

of the company is prescribed in section Effectiveness Section Accountability makes boards responsible for “determining the nature and extent of the principal risks it is willing to take” (p 5) as well as maintaining sound risk management and internal control systems and appropriate relationship with auditors Section Remuneration requires existence of transparent procedures,

no director involvement in decision-making about remuneration of one’s own self, encourages companies to pay not more than necessary and to link significant part of the remuneration with performance (Murphy & Cronin, 2012) Finally, section Relations with shareholders places responsibility on boards to ensure satisfactory dialogue with shareholders and promoting their participation (Financial Reporting Council, 2014)

Following discussion regarding corporate governance systems in other countries are based on review of Knapp (2012)

The French Commercial Code obliges all the companies with registered offices in France and

with financial securities admitted to trading on a regulated market to adhere to the corporate governance code, published by the French Association of Private Sector Companies and the French Business Confederation, or the Middlenext code in case of small and mid-sized companies Although French markets regulator (AMF) is not empowered to apply any disciplinary actions for non-compliance with the corporate governance codes, publication of detailed annual report on general application of corporate governance rules forces companies included in French stock market indices such as CAC40 and SBF120 to strictly adhere to recommendations

According to the German Stock Corporation Act recommendations and suggestions provided

by German Corporate Governance Code are required to be applied by listed corporations,

partnerships limited by shares, European companies incorporated in Germany, also non-listed German incorporated companies if they have issued financial instruments other than shares for trading on a regulated market within the European Economic Area, or have their shares traded

4 AIM (Alternative Investment Market) is the “London Stock Exchange’s international market for smaller, growing companies Businesses on AIM operate under a more flexible regulatory environment than the Main Market of the Exchange” (London Stock Exchange Group, n.d., p 238)

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on a multilateral trading facility (MTF) However, no specific body has the power to formally monitor and review companies’ compliance, therefore, ultimate responsibility lays on shareholders

All listed companies with their statutory seat in the Netherlands and shares or depositary receipts for shares admitted to an MTF in the European Union (EU) or any similar system

outside the EU are obliged by the Dutch Civil Code to adhere to the Dutch Corporate Governance Code Compliance is monitored by the Dutch Corporate Governance Code

Monitoring Committee, while disclosure of compliance statement is verified by Dutch Financial Markets Authority

All issuers of securities that are admitted to trading on a regulated market in Italy are required

to disclose key elements of their governance structure and practices pursuant to the Italian Consolidated Financial Act In case of voluntary adoption of the Italian Corporate Governance Code, companies should make reference to particular recommendations that were implemented

Mid-sized companies admitted to the STAR segment of the MTA market5 organized and managed by Borsa Italiana (the Italian Stock Exchange), have obligation to comply with only part of the recommendations Adherence and implementation is checked at different levels, in particular, the board of statutory auditors of each issuer is responsible for overseeing proper adoption of the code; the Italian Securities and Exchange Commission (Consob) controls disclosure of compulsory information, as well as compliance in case of the code adoption; and finally, Italian Association of Joint Stock Companies (Assonime) analyses degree of Corporate Governance Code implementation in listed companies annually

Pursuant to the Spanish Securities Market Act, all companies domiciled and listed in Spain must adhere to the Spanish Corporate Governance Code and publish annual report containing

comprehensive information about their governance structure and practices The Spanish Stock Exchange Commission is in charge of monitoring overall compliance with the code

Evidently, corporate governance frameworks as well as monitoring of their application are far from uniformity even in discussed six countries However, increased calls for more harmonized approach within members of European Union might gradually lead to convergence of applied corporate governance practices

1.3 Changes in corporate governance in regard to the global financial

crisis

Financial crisis of 2008 indicated existing shortcomings in corporate governance and motivated further investigations of them As a result, in 2009-2010 the OECD Steering Group on Corporate Governance presented analysis of weaknesses in corporate governance, their contribution in development of crisis and finally, conclusions and recommendations with regard

to discussed issues in three documents: The Corporate Governance Lessons from the Financial Crisis (2009), Corporate Governance and the Financial Crisis: Key Findings and Main Messages (2009), Corporate Governance and the Financial Crisis: Conclusions and emerging good practices to enhance implementation of the Principles (2010)

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First of all, The Corporate Governance Lessons from the Financial Crisis (2009) concludes

that weak corporate governance procedures can be treated as causes of financial crisis to a significant extent Some of the examples of corporate governance failures include: inefficiency

of remuneration system in aligning management’s interest to those of shareholders; lack of communication between senior management, risk management staff and board partly attributable to a silo approach6 to risk management as reported by UBS7 and lack of thorough understanding of risk measurement methodologies applied in banks by strategy and planning functions as stressed by two thirds of large European banks in interviews held by Ladipo et al (2008, p 45) However, main source of financial crisis was not the inefficiency of existing principles, but rather, insufficient and patchy implementation of them Consequently, based on the key findings of abovementioned research, the OECD Steering Group on Corporate Governance suggests following supplements regarding five key areas:

1 Ensuring the basics for an effective corporate governance framework

According to report, attention should be paid to proper implementation of existing standards in order to avoid “box ticking” i.e only formal compliance to Corporate Governance Codes In addition, authorities are encouraged to regularly review the relevance of current corporate governance rules in accordance with market developments

2 Governance of remuneration and incentives

Since overly complicated remuneration schemes with limited downside risk hinders boards to effectively oversee executive remuneration, the plans are advised to be simplified and focused on creating linkage between compensation and long-term interests of the company at the same time achieving “symmetry between the upside and downside performance-based compensation” (p 9) Good practices outlined include increasing the role of non-executives in the process and submission of remuneration policies and implementation measures to the annual meeting

3 Improving the governance of risk management

As also discussed in Corporate governance principles for banks, good practice is to

separate risk-management and control functions from profit centers, thus, appointing executive officer with considerable independence from CEO and direct accountability

to board of directors (Basel Committee on Banking Supervision, 2015) Another issue has been related to readability of risk disclosures, therefore, risk assessments results have been suggested to be presented in a transparent and understandable fashion

4 Improving board practices

Dominance of boards by CEO has been reported to be one of the impediment for objective judgement exercised by boards Subsequent suggestion underscores importance of Chair of the board to play a key role and in case of CEO duality, necessity

to disclose measures taken in order to avoid conflicts of interest Other advices discussed are promoting competent boards by for example providing access to training programs and carrying out board evaluations; improving board independence and objectivity via determining term limits on board membership; dealing with complexity through “setting

6 A “Silo-based” approach refers to traditional risk management approach, where different categories of the risk are managed separately, for example in financial institutions market, credit, liquidity, and operational risks might

be addressed separately in individual risk silos (Liebenberg & Hoyt, 2003)

7 Cited according to The Corporate Governance Lessons from the Financial Crisis, OECD, February 2009, p 11

available at http://www.oecd.org/finance/financial-markets/42229620.pdf

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clear lines of responsibility and accountability throughout the organisation, including subsidiaries, key partnerships and other contractual relations” (p 22)

5 The exercise of shareholder rights

Good practices in this area include disclosure of voting records by institutional investors

to their clients, for whom they act in a fiduciary capacity; making references to codes

of principles and their implementation In the end, due to increased influence of proxy advisors, authorities are encouraged to ensure competitive market for these services and

“monitor the management of conflicts of interest by advisors” (p 30)

In the aftermath of financial crisis, the UK government also commissioned analysis and subsequent recommendations that are presented in the Walker (2009) report (Tannaa, Pasiouras,

& Nnadi, 2011) In total 39 recommendations are divided into 5 parts and relate to: Board size, composition and qualification, Functioning of the board and evaluation of performance, The role of institutional shareholders: communication and engagement, Governance of risk, and Remuneration Noticeably, issues covered are similar to those, already discussed above In addition, significant emphasis is put on time commitment of board chairman, as well as non-executive directors, who are also required to have sufficient knowledge and understanding of the business (Walker, 2009)

Overall, both set of principles (BCBS, OECD) and supplements taking into account roots of reasons of financial crisis are aimed to minimize possibility of its reoccurrence Their effectiveness will depend on their complete and successful implementation by all the participants of corporate governance process and will be tested through time

1.4 Empirical evidence on the effects of corporate governance on bank

performance

As already discussed above, literature doesn’t provide exhaustive definition for corporate governance that would lead to uniformity in empirical studies As a result, for the purposes of understanding relations between corporate governance and financial performance in banks, researchers address different aspects or employ designed indices, which covers several facets simultaneously Two relatively widely used corporate governance mechanisms are board size and independence Below we provide review of empirical evidence with respect to each of them separately Afterwards, we discuss existed literature about other less investigated aspects, such

as for example CEO pay-performance sensitivity or frequency of board meeting

Board size is one of the components of internal corporate governance Although, evidence regarding its effectiveness is not straightforward Table 2 summarizes results of empirical studies in this regard

Evidently, most of the studies that examine impacts of board size in banks find positive association between number of board members and different measures of financial performance, while two of them report existence of inverted U-shaped relationship, meaning that after certain point, increased board size doesn’t contribute to shareholder value creation Benefits of large boards can be attributed to increased pool of experience and resources that enhances advisory and monitoring roles of boards, however when interpreting results, we should take into account possibility of reverse causality, which is not properly addressed in most of the studies presented here (de Haan & Vlahu, 2015)

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In order to explore influence of board size on banks market or accounting-based performance,

we discuss some of the researches disclosed in Table 2 into more details Agoraki, Delis and Staikouras (2010) and Tannaa, Pasiouras and Nnadi (2011) both investgate impact of board structure on bank efficiency in Europe and specifically in the UK respectively While former finds negative relationship between board size and cost and profit efficiency, the latter reports positive influense, although not robust through all the specifications Negative association of board size with financial and operational performance of European banking system, measured with ROE, ROA and Tobin’s Q is also reported by Staikouras et al (2007) At the same time, Adams and Mehran (2012) provide evidence in favor of large boards in U.S Bank Holding Companies (BHCs)

Table 2 ─ Recent studies on board size and bank performance

de Andres and Vallelado (2008)

Canada, France, Italy, Spain, the

UK, U.S

69 large banks 1995–2005 Inverted U-shaped

relationship Grove et al (2011) U.S 236 banks 2005–2008 Inverted U-shaped

relationship Adams (2012) U.S 89 banks 2008–2009 Positive

Adams and Mehran (2012) U.S 35 bank holding

companies (BHCs) 1964–1985 Positive Aebi et al (2012) U.S 372 banks 2007–2008 Positive

Beltratti and Stulz (2012) International

sample 164 large banks 2007–2008 Positive Tannaa et al (2011) UK 17 banking

institutions 2001-2006 Positive Faleye and Krishnan (2010) U.S 51 banks 1994–2006 Negative

Wang et al (2012) U.S 68 BHCs 2007 Negative

Staikouras et al (2007) Europe 58 large banks 2002–2004 Negative

Agoraki et al (2010) Europe 57 large banks 2002-2006 Negative

Source: Author’s own compilation

Taking into account the idiosyncratic nature of banking industry and its influence on application

of corporate governance mechanisms, de Andres and Vallelado (2008) emphasize importance

of boards of directors, in particular their monitoring and advising function In their study of 69 large commercial banks from Canada, France, Italy, Spain, the UK, and the U.S for the period

of 1995-2005, authors demonstrate existence of “an inverted U-shaped relation” between board size, fraction of non-executive directors and bank performance; meaning that, both independent variables are characterized by diminishing marginal returns and therefore, optimum number of board members should be determined as well as level of board independence in order to create shareholder value

Another important dimension of board structure is independence Implications of different levels of independence is not straightforward even theoretically For example, more independent boards are expected to monitor management properly since their compensation is not linked to short-term objectives and they are concerned about their reputation (de Haan & Vlahu, 2015) However, increased independence in unitary board system might lead to lack of information, provided by managers and thus cause adverse consequences, such as reduction of boards monitoring function (Adams & Ferreira, 2007) Table 3 presents short summery of conducted empirical researches regarding board independence Interestingly, evidence is as

Table 3 ─ Recent studies on board independence and bank performance

de Andres and Vallelado (2008)

Canada, France, Italy, Spain, the

UK, U.S

69 large banks 1995–2005 Inverted U-shaped

relationship Agoraki et al (2010) Europe 57 large banks 2002-2006 Non-linear

Pi and Timme (1993) U.S 112 banks 1987–1990 Not significant

Adams and Mehran (2012) U.S 35 BHCs 1964–1985 Not significant

Adams and Mehran (2008) U.S 35 BHCs 1986-1996 Not significant

Berger et al (2012) U.S 328 commercial

banks 2007–2010 Not significant Fernandes and Fich (2009) U.S 398 banks 2007–2008 Not significant

Aebi et al (2012) U.S 372 banks 2007–2008 Negative but mostly

insignificant Beltratti and Stulz (2012) International

sample 164 large banks 2007–2009 Negative Wang et al (2012) U.S 68 BHCs 2007 Negative

Cornett et al (2010) U.S All publicly traded

BHCs 2003–2008 Positive Cornett et al (2009) U.S 100 largest BHCs 1994–2002 Positive

Mishra and Nielsen (2000) U.S 89 largest BHCs 1975–1989 Positive

Tannaa et al (2011) UK 17 banking

institutions 2001-2006 Positive Staikouras et al (2007) Europe 58 large banks 2002–2004 Positive but mostly

insignificant

Source: Author’s own compilation

While studying large, publicly traded U.S bank holding companies, Adams and Mehran (2008) find that proportion of independent board members is not significantly related to performance, measured by Tobin’s Q; However, Cornett et al (2009) argue that strong board of directors is significantly positively related to bank performance, as proxied by earnings before extraordinary items and after taxes to total year-end assets Furthermore, authors claim that corporate governance mechanisms, such as CEO pay-for-performance sensitivity, board independence, the Tier 1 capital ratio, are simultaneously determined along with performance and earnings management As a result of addressing endogeneity by applying two-stage least

22

squares regressions, they reveal negative relationship between performance, board independence, and capital and earnings management; meaning that, if a bank performs well, has a strong independent board of directors and sufficient level of capital, management is less likely to engage in artificial inflation of earnings by usage of loan loss provisions and securities gains and losses

Similarly, effects of board independence and pay-performance sensitivity on bank holding companies’ performance is examined by Mishra and Nielsen (2000) Authors document a positive influence of relative tenure of independent outside directors and CEO pay-performance sensitivity on accounting performance, but negative impact of their cross product, which indicates substitution relation between them; although, it’s worth mentioning that when two-stage least squares method is applied, pay-related incentives and the percentage of independent outside directors show complementary relation Mentioned empirical results suggest that once CEO compensation programs are set in accordance with shareholders’ interests, added value of increase of independent directors’ proportion decreases

Several studies specifically concentrate on examining linkages between corporate governance and banks’ performance during or in immediate aftermath of the recent financial crisis of 2008 Particularly, based on research of 62 large publicly traded U.S banks Peni and Vähämaa (2011) find that strong corporate governance, quantified with the index of Brown and Caylor (2006, 2009), was associated with higher profitability, although decreased stock market valuations of banks amid crisis However, further observation of subsamples and subperiods reveals significant and positive impact of corporate governance on stock returns, indicating that later

on strong corporate governance structures helped banks to reduce negative effects of financial crisis

As for European banks’ performance amidst market turmoil, study of 97 largest banks demonstrates different effects of various aspects of corporate governance (Felício, Rodrigues, Ivashkovskaya, & Stepanova, 2014) In particular, frequency of board and committee meetings (audit committee, compensation committee) appear to have positive significant influence on performance, as measured by ROA One of the reasons behind might be improved communication between executive and monitoring function Higher age of directors is also reported to have positive influence on operating performance as well as on market valuation that could be attributed to a greater professional experience accumulated by directors It is worth mentioning that authors do not find statistically significant effect of CEO duality, busyness of directors, blockholdings, anti-takeover measures, relative power of insiders and other corporate governance mechanisms on any measures of performance (ROA, Book to Market Ratio, Net Interest Margin) On the other hand, size of banks and location of headquarters in more developed countries, as proxied by GDP per capita are associated with lower profitability and accordingly, lower operational performance

The last particular aspect of corporate governance that we cover in our review is organization

of board of directors as one-tier (OTS) or two-tier (TTS) structure.8 De Simone (2012) studies its impact on bank performance and risk exposure in Euro-area and UK Results suggest that risk exposure as measured by distance to default is higher and statistically significant during the financial crisis in banks which have adopted OTS; on the other hand, the abovementioned banks outperform the rest according to operational performance, that might be attributed to lower costs related to one-tier board structure; however, same result doesn’t apply to financial performance as proxied by abnormal returns Even though, overall evidence doesn’t support distinct superiority of either corporate governance pattern, it still indicates necessity to increase

8 Unlike Anglo-American one-tier board model, most European countries have two-tier system, consisting of a supervisory board and a management (executive) board (de Haan & Vlahu, 2015)

1.5 Empirical evidence on the effects of corporate governance on

insurance companies’ performance

Corporate governance studies in insurance companies are somewhat similar to those in banking industry in terms of observed aspects, however, there still exist some differences Table 4 summarizes reviewed literature regarding insurers, although since empirical evidence is relatively scarce than in case of banks, we present different investigated features together As evident in Table 4, most of the studies concentrate on risk-taking behavior in insurance industry, rather than profitability or market performance Another peculiarity of studies in this regard is variation in organizational structures of insurance companies, which allows scholars to explore its implications in reality Below we discuss each of these works separately

Based on research of life insurers in the UK, Hardwick et al (2011) suggests that corporate governance is a complex system and possible interactions among different aspects should be taken into account while forming opinion about their effectiveness One of the underlying results leading to such conclusion is that CEO duality per se doesn’t show any significant influence on profit efficiency, however, in case of separation of the CEO and board chairman positions and absence of audit committee, impact of board independence measured by representation of non-executive directors on the board, becomes statistically significantly positive

Two other studies that examine factors other than risk-taking are He and Sommer (2011) and

He, Sommer, and Xie (2011) Both researches are based on the same sample, namely 423 mutual and 1,516 stock insurance companies in the property–liability insurance industry within time period of 1996–2004 While the former investigates how organizational structure affects CEO turnover, the latter concentrates on post turnover developments, in particular the issue under consideration is whether companies’ financial performance improves The results suggest that likelihood of CEO turnover based on poor performance is significantly higher in stock firms than in mutual firms while CEO turnover for its part, positively affects insurers’ post-turnover performance as measured by cost efficiency and revenue efficiency scores

The interest in case of the other studies lies in how various mechanisms of corporate governance influence specific types of risks or risk-taking behavior in general Ho, Lai and Lee (2013) find that compared to stock insurers, mutual insurers tend to have lower total risk, including underwriting and investment risks As for board composition, CEO duality is found to be associated with increased level of leverage risk; larger representation of insiders on boards lead

to higher total risk, while large board size is related to both, higher leverage and total risks (although lower investment risk), naturally pointing to importance of addressing different types

of risks separately

On the contrary, Venuti and Alfiero (2016) show that in European insurance industry held insurance companies are associated with lower risk in comparison with those, held privately In addition, they report that larger board size, as well as higher ownership concentration is significantly correlated with lower risk since the higher the number of directors

publicly-on the board, the harder for them to unanimously agree publicly-on engaging in risky projects

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Other aspect of corporate governance that deserves attention is institutional ownership Study held by Cheng, Elyasiani, and Jia (2011) explores its effects on life–health insurers’ risk-taking behavior According to the results, stable institutional ownership leads to decreased level of overall risk, although when investigated in details, authors find that institutional ownership stability increases investment risk, while decreasing underwriting risk and leverage

Table 4 ─ Recent studies on corporate governance in insurance companies

Span

Independent Variable

1994–2004 Number of directors

and its square Profit efficiency Not significant

Proportion of nonexecutive directors on the board

Profit efficiency

Significantly positive or negative depending on whether there is separation of the CEO and board chairman positions and whether there is an audit committee

1996–2004 Organizational

structure

Chief Executive Officer (CEO) turnover

Likelihood of CEO turnover based on poor performance is significantly higher in stock firms than in mutual firms

1996–2004 CEO turnover

Post-turnover cost efficiency and revenue efficiency scores

risks Positive Board size Investment risk Negative Venuti and

Alfiero

(2016)

126 insurance companies from the 27

EU Countries

2009–2013 Organizational

structure Risk-taking

Publicly-held insurance companies are associated with lower risk

Board size Risk-taking Negative Cheng,

Downs and

Sommer

(1999)

55 traded property- liability insurers

1989–1995 Insider ownership Risk-taking Positive

Eling and

Marek

(2013)

35 insurance companies in the UK and Germany

1997–2010 Compensation Risk-taking Negative

Monitoring Risk-taking Negative Ownership structure Risk-taking Negative

Source: Author’s own compilation

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Downs and Sommer (1999) employ insider ownership as a corporate governance mechanism and document positive association between property–liability companies’ rick-taking behavior and managerial ownership Mentioned linkage is especially stronger in less capitalized firms, however, it diminishes as the level of ownership increases

Finally, Eling and Marek (2013) examine insurance industry in the UK and Germany and address compensation, monitoring, and ownership structure as determining corporate governance factors of risk-taking behavior The main result of the research is to confirm existence of significant influence of all mentioned elements on risk taking; more precisely, all three are found to be negatively correlated with firm risk, meaning that companies with more independent board members, more frequent board meetings, higher number of blockholders and higher levels of compensation engage in less risk taking (Eling & Marek, 2013)

Diversity of the empirical studies presented above once again demonstrates complexity of the concept and motivates further research in this regard in order to supplement gaps in existing literature

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2.1 Definition and importance

Concept of Corporate Social Responsibility has undergone several stages of evolution While describing historical development of definition throughout 1950s-1990s, we largely allude to

an extensive literature review conducted by Carrol (1999)

The title ─ “Father of Corporate Social Responsibility” according to Carrol (1999) should be attributed to Howard R Bowen, who in 1953 introduced an initial definition of CSR which

“refers to the obligations of businessmen to pursue those policies, to make those decisions, or

to follow those lines of action which are desirable in terms of the objectives and values of our society” (p 270) The successor of Bowen in terms of importance of contribution is Keith Davis (1960), who further expanded a CSR definition and related it with activities motivated by interests, other than economic ones; however, he still justifies socially responsible decisions with payoff received by the company in long run (Carroll, 1999) In 1973 Davis again emphasized that firms are obliged to make decisions taking into account not only expected economic results, but also social benefits; meaning that socially responsible firms do more than what is merely required from them by law Committee for Economic Development (CED) in

1971 outlined three circles definition of CSR:

“The inner circle includes the clear-cut basic responsibilities for the efficient execution of the

economic function — products, jobs and economic growth

The intermediate circle encompasses responsibility to exercise this economic function with a

sensitive awareness of changing social values and priorities: for example, with respect to environmental conservation; hiring and relations with employees; and more rigorous expectations of customers for information, fair treatment, and protection from injury

The outer circle outlines newly emerging and still amorphous responsibilities that business

should assume to become more broadly involved in actively improving the social environment (For example, poverty and urban blight)” (p 275)

In 1979 Carroll attempted to articulate an exhaustive definition of CSR, stating that “the social responsibility of business encompasses the economic, legal, ethical, and discretionary expectations that society has of organizations at a given point in time” (p 500) Later on he specified discretionary part of definition and included voluntarism and/or philanthropy instead (Carroll, 1983) Economic, legal, ethical, and philanthropic categories of CSR ultimately were suggested to be depicted as a pyramid for the sake of graphical depiction (Carroll, 1991) In short, according to Carroll “The CSR firm should strive to make a profit, obey the law, be

ethical, and be a good corporate citizen” (op cit., p 43)

On the international meeting organized by the World Business Council for Sustainable Development (WBCSD) following formal definition for CSR has been emerged: “Corporate social responsibility is the continuing commitment by business to behave ethically and contribute to economic development while improving the quality of life of the workforce and

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their families as well as of the local community and society at large” (The Netherlands, 6 – 8 September 1998).9

Importance of corporate social responsibility can be explained from different perspectives First

of all, number of companies engage in socially responsible activities as a response to existed social, environmental and economic pressures (European Commission, 2001) Despite the fact that financial companies’ exposure to environmental risks is relatively low, financial sector still experiences tough societal scrutiny (Louche & Van den Berghe, 2005) On the other hand, drivers of CSR can also be proactive, namely, superior performance on corporate social responsibility strategies might be viewed as a competitive advantage in attracting high quality workforce, at the same time increased transparency can contribute to better access to finance and ultimately improve companies’ financial performance (Greening and Turban, 2000; Cheng, Ioannou, and Serafeim, 2014) The UN Global Compact-Accenture CEO Study on Sustainability 2013 provides additional support for CSR importance by finding that out of surveyed 1000 top executives from 27 industries across 103 countries, 93% regard sustainability as key factor to success

Despite importance of the topic, there’s little evidence on the linkages between corporate social performance and various measures of firm success, especially in financial companies Section 2.2 further explores existing literature in this regard

2.2 Empirical evidence on the effects of CSR on financial institutions’

performance

Empirical research examining CSR in financial institutions are extremely scarce, while those focusing on only insurance companies, to the best of our knowledge, are almost nonexistent Study of linkage between CSR/CSP and financial performance in numerous industries simultaneously has not resulted in straightforward unquestionable opinion about the issue One

of the obstacles in this field is difficulty to specify and measure social responsibility Remedies

to abovementioned quantification problem are not simply prescribed and are matter of researcher judgement Soana (2011) outlines several commonly used methods in the literature,

in particular:

 Content analysis ─ draws opinion about company’s CSR based on the related information, published by the company Although this method can foster creation of larger samples due to its mechanical characteristic, its applicability is still arguable; more concretely, general expectation is that if firms discuss the issue in their annual reports, most probably they also act on them, however, there might exist companies with less sense of integrity, that might try to create good public image just by proclaiming something they haven’t done at all (Cochran & Wood, 1984)

 Questionnaire surveys ─ researchers distribute specially developed questionnaire forms among managers and directors and based on the result analysis, try to assess companies’ attitude towards corporate social responsibility Drawbacks associated with the method

is high level of subjectivity and difficulty to apply managers’ personal perceptions to firms’ corporate social performance

9 Cited according to Meeting Changing Expectations, Corporate Social Responsibility World Business Council

for Sustainable Development (WBCSD), p 3 available at:

http://www.wbcsd.org/pages/edocument/edocumentdetails.aspx?id=82&nosearchcontextkey=true

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 One-dimensional indicators ─ proxy CSP by evaluating one particular aspect of the concept; as an example usage of data about companies’ environmental impact or philanthropic activities to judge their corporate social performance

 Reputational measures and Ethical rating ─ these metrics are ratios or indices developed

by some authors, journals or agencies in attempt to quantify companies’ CSP and enable their ranking Method’s disadvantage is absence of a generally accepted methodology that results in disparity of published information (at its extreme, inconsistent rankings

of the very same firms by different agencies)

Historically, Henry Eilbert and I Robert Parket (1973) were among those who started to associate CSR with organizational variables and to research how the concept began to be applied in business practices, whereas in 1980s scholars developed their interest in investigation

of relationship between CSR and company’s financial performance (Carroll, 1999) For example, Cochran and Wood (1984) examined abovementioned relationship in companies from different industries and documented weak existence of it after controlling for asset age (which was found to be significant in determining CSR ranking)

CSR studies, especially concentrated on banking sector are of particular interest due to following reasons: through involvement in CSR activities, banks can compensate for receiving public resources, such as taxpayers’ funds while being bailed out; furthermore, via landing activities, banks can play important role in development of ethical or unethical industries; and finally, as duration of financial products and underlying financial relationships usually exceeds one year, establishment of excellent reputation is essential for attracting new and maintaining existing customers (Shen, Wu, Chen, & Fang, 2016) Chih, Chih and Chen (2010) study additional factors enlisted by Campbell (2007) that might incentivize financial firms to engage into CSR activities and test the relationships empirically Research of 520 financial firms in 34 countries in 2003-2005 reveals that larger companies due to greater public attention tend to act

in more socially responsible ways, while their financial performance as measured by ROA is found to be insignificant for explaining companies’ inclination to CSR activities Other conditions positively influencing decision about CSR adoption include intense market competitiveness, as a stimulus to gain competitive advantage over rivals; operation in a country with strong level of legal enforcement, cooperative employer–employee relations, higher quality management schools, and a better macroeconomic environment, as well as existence of self-regulation within the financial industry In consistence with abovementioned study, Andrikopoulos, Samitas and Bekiaris (2014) find that larger financial institutions listed in the Euronext stock exchange, disclose information about their CSR practices more extensively Furthermore, authors reveal positive relation between financial leverage and CSR disclosure, which they attribute to increased demand for information from stakeholders

Table 5 provides short summary of empirical researches that examine linkage between CSR and profitability in financial institutions Bellow we discuss these and other studies into more details in order to create deeper understanding of the relation under consideration

Soana (2011) has attempted to fill the existing gap in empirical investigation by analyzing 21 international banks as well as 16 and 31 Italian banks, rated by different agencies in 2005 Results do not support existence of any significant relation between CSP and Corporate Financial Performance (CFP); deeper investigation of individual components of CSP indicates contradictory results for different samples, which ultimately leads to conclusion that Italian

as well as earning measure (Net interest income and Non-interest income ratios) is significantly positive at the same time negatively associated with non-performing loans Obtained results suggest that in the researched sample of banks, strategic motive is the main determinant of engagement into CSR activities

Banking industry but in the U.S in 1993-1994 is studied by Simpson and Kohers (2002) Obtained results show positive linkage between CSP and financial performance, measured by ROA and loan losses; particularly, average bank from the group of outstanding social performance (rated in accordance with the Community Reinvestment Act of 1977 (CRA)) was approximately 78 percent more profitable and experienced almost twice lower level of loan losses than average bank with poor social performance

In order to examine linkage between corporate environmental responsibility (CER) and companies’ financial performance, Jo, Kim and Park (2015) investigate broad dataset comprising of companies from different industries of financial services sector (such as Banks, Securities, Real estate and Insurance companies) across 29 countries in 2002-2011 Results show existence of negative effects of environmental costs on ROA, meaning that decrease in total environmental costs (direct and indirect) can lead to improved financial performance Findings support the social impact and reputation-building hypothesis which suggests aforementioned improvement due to different reasons, among them growing reputation, attraction of better qualified and motivated workforce, decreased regulatory risk and hence, lower cost of capital Regional and industrial comparison revealed not less interesting results;

in particular, it appears that in Europe and North America CER activities are reflected in improved CFP at a larger extent than in the Asia Pacific region, however required time to receive returns on CER investments depends on development of financial markets and varies between 1-2 years As for the industries, authors recognize banks as “the most eco-friendly” institutions among those researched, while securities industry is characterized with the highest ratio of total environmental costs to total assets

Supporting evidence for social impact hypothesis is also reported by Shen, Wu, Chen and Fang (2016) whose research focus is concentrated on large data-set of global banks in 18 countries Distinguishing factor of the mentioned work is utilization of two matching methods (conventional propensity score matching method and nearest-neighbor variance bias-corrected matching method) as well as Heckman's two-step method in order to identify “statistically identical” banks and analyze CSR effects by applying ordinary least squares (OLS) and the seemingly unrelated regression (SUR) According to the obtained results, in most of the specifications, engagement in CSR activities is found to be positively related to the different measures of performance, such as ROA, ROE, Net interest income and Non-interest income

10 “Greenwashing refers to the disingenuous act of companies to spin their products and policies as friendly, such as presenting cost cuts as reductions in resource use” (Wu & Shen, 2013, p 3530)

environment-30

ratios, while negatively associated with the Non-performing loan ratio, suggesting overall favorable impact of CSR activities in banking sector In the end, authors also emphasize importance of “other things being equal”-principle and relate previous inconclusive findings

to estimation methods used before

Table 5 ─ Recent studies on CSR and financial institutions’ performance

16/31 Italian banks 31-12-2005 / 01-04-2005 Not significant

Jo, Kim and Park (2015) Financial services sector

Shen, Wu, Chen and

Fang (2016)

65 CSR and 6060 CSR global banks in 18 countries

Simpson and Kohers

Source: Author’s own compilation

Finally, we review studies which do not specifically measure effects of CSR on financial performance, although cover different relevant aspects of social responsibility in financial institutions

General CSR performance of financial sector in comparison with other sectors is studied by Weber, Diaz and Schwegler (2014) As expected, financial sector performs less than energy, materials, consumer staples and materials with respect to CSR and roughly same as other services sectors, such as consumer discretionary, health care, information technology and telecommunications due to relatively lower pressure on the financial sector However, community relations can be treated as strength of the sector, that can be attributed to rising importance of reputational risks and need for those risks to be managed through project finance, credit business, insurance products and other financial products and services

Scholtens (2009, 2011) has developed a cross-sectional analysis framework in order to study

32 banks and 153 insurance companies across Europe, North America and Asia Pacific regions with respect to CSR In case of banks although author doesn’t find significant differences on a regional basis, diversity is notable at a country and especially at an individual level Remarkable results of the study include following facts: overall, number of banks as well as the aspects of CSR covered have increased significantly in 2005 in comparison with 2000; progress is documented in all three regions, Asia Pacific being a leader in relative improvement; based on correlation coefficients, significant association exists between banks’ CSR performance and financial quality as measured by banks’ tier 1 capital ratio (Scholtens, 2009) As for insurance companies, main difference from banks based on these two studies is that European and Japanese insurance companies outperform North American counterparts in most of the CSR aspects researched; however, different CSR policies are not implemented into business activities at a same degree, namely, when it comes to donations/sponsoring or voluntary work, insurers perform significantly better than in environmental aspects (Scholtens, 2011) Similarly

to banks, engagement in CSR activities is positively correlated with size of insurance companies, that might be explained by increased attention from stakeholders related to

31

company growth (Waddock & Graves, 1997) Otherwise, on an industry basis banks show notably superior performance in every single CSR aspect observed both in Europe and North America

Clearly, there is a considerable room for further research with respect to corporate social responsibility, especially when it comes to insurance companies In this thesis we attempt to contribute to existing literature regarding CSR by identifying and measuring impact of various features of social responsibility on financial performance in European banks and insurance companies

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GOVERNANCE AND CORPORATE SOCIAL

RESPONSIBILITY ON FINANCIAL INSTITUTIONS’ PERFORMANCE

3.1 Data

In this study we aim to analyze importance of corporate governance and social responsibility in banks and insurance companies by examining its influence on different measures of financial performance, such as Tobin’s Q, Return onCommon Equity, Return on Assets and Market to Book ratio We focus on European publicly traded banks and insurance companies within the period of 2000-2015 The data are collected from Bloomberg Due to poor extent of firms’ Environmental, Social and Governance disclosure, our primary sample has been reduced to 98 banks and 40 insurance companies within time frame of 2005-2015 Since there is little theoretical guidance about precise measurement of corporate governance and social responsibility, as well as about exact design of specifications, we select groups of variables based on the emphases placed in literature and also taking into account the accessibility of corresponding data in Bloomberg

Table 6 summarizes the chosen variables in order to proxy relevant aspects of corporate governance and social responsibility All the variables are retrieved from Bloomberg and further explanations are based on the data and definitions provided in the mentioned system

First we start with ESG disclosure score, which reflects overall extent of ESG disclosure Score

is provided by Bloomberg It is based on large pool of data points and is not directly associated with the weighted sum of variables presented here Scoring takes into account the importance

of data points and their relevance to particular industry, thus each company is evaluated in the context of the industry sector that it belongs Table 7 provides descriptive statistics regarding European banks within the time frame of 2000-2015 As depicted in the table, the range of disclosure score is quite wide between 3.51 and 79.39, however, the mean and median values are close to each other amounting 32.57 and 33.77 respectively As for insurance companies, figures are rather similar in all dimensions pointed out above Corresponded summary statistics are reported in Table 8 Correlation matrices for each dataset can be found in Appendix 1 Next we try to cover corporate governance aspects by including six frequently used proxies, particularly: board size, percentage of women on the board of directors, percentage of independent directors and presence of CEO duality all measure general structure and board composition In addition, they serve as a proxy for relative independence, objectivity and monitoring power of the boards; number of board meetings for the year quantifies communication between board members and finally, dummy variable for unitary and two-tier board systems depicts two major structures of governance On average, board size in banks from our sample are somewhat larger in comparison with insurance companies with median values of 13 and 11 full time directors respectively Women representation on boards in minimum cases is completely non-existent, although at its maximum, it can reach up to almost 60% In addition, on average, percentage of female directors on the board is higher in insurance companies than in banks European insurers also outperform banks in board independence as measured by percentage of independent directors, however in both sectors, share of independent directors can reach to the maximum level of 100% Also when we look at the CEO duality as another proxy for board independence, median values of 0 in both sectors indicate acknowledged high importance of the issue in European banks and insurance companies Finally, intensity of communication between board members is definitely higher in banking,

33

reaching 73 meetings in one year at its maximum Among other reasons, cause of more frequent meetings can be larger size of the boards, which arises necessity of communication improvement Other things being equal, we expect percentage of independent directors and number of board meeting per year to be positively associated with financial performance due

to enhanced monitoring power, as opposed to CEO duality

What concerns measurement of CSR, literature in this regard is even more ambiguous, while data disclosed by the companies is even scarcer One of the reasons for poor disclosure can be financial companies’ relatively low exposure to environmental risks (Louche & Van den Berghe, 2005)

Table 6 ─ List and definitions of chosen variables

Number of Board

Meetings for the

Year

Total number of corporate board meetings held in the past year

Size of the Board

Number of full time Directors on the company's board Deputy members of the Board are not counted In Europe where the company has a Supervisory Board and a Management Board, this is the number of Directors on the Supervisory Board

CEO Duality Dummy variable that equals to 1 if the company's Chief Executive Officer

is also Chairman of the Board and to 0 otherwise

Turnover %

Number of employees that left the company within the past year expressed

as a percentage of the average total number of employees

Policy

Dummy variable that equals to 1 if the company has implemented any initiatives to ensure the protection of the rights of all people it works with and to 0 otherwise

34

Due to these constraints we came up with the seven possible proxies that are meant to assess different aspects of socially responsible behavior We use energy intensity per employee, which measures consumed energy standardized by number of employees in order to evaluate firms’ environmental responsibility The rest of the variables within the group mostly concentrate on social aspect In particular, percentage of employee turnover attempts to quantify company’s attractiveness as an employer High employee turnover may indicate unsatisfying working conditions, including compensation, health and safety provisions, etc Tables 7 and 8 report that along this dimension banks outperform insurance companies with relatively lower level of employee turnover Greening and Turban (2000) conducted an experiment and found that prospective job applicants prefer to be considered for job offers from socially responsible firms and are more likely to pursue jobs in companies with better social performance reputation If

we assume that the reputation at least partly reflects the true facts, attractive companies should also be characterized with lower employee turnover Naturally, due to recruitment of high quality workforce and reduced costs as a result of their retention, we expect lower levels of employee turnover to be linked to increased financial performance.

(Trailing 12 Months Net Income Available for Common Shareholders / Average Total Common Equity) * 100

Other assets, Customers' Acceptances and Liabilities

For Insurance companies Total assets is the sum of Cash & Near Cash Items, Net Receivables, Total Investments, Net Fixed Assets, Deferred Policy Acquisition Costs, and Other Assets

Volatility

A measure of the risk of price moves for a security calculated from the standard deviation of day to day logarithmic historical price changes The 360-day price volatility equals the annualized standard deviation of the relative price change for the 360 most recent trading days closing price, expressed as a percentage

Financial

Leverage

Measures the average assets to average equity Calculated as: Average Total Assets / Average Total Common Equity

Type of Insurance Dummy variable that equals to 1 for Life insurance, to 0 in case of P&C

(property and casualty) Insurance and to -1 for Reinsurance

Source: Adapted in accordance with Bloomberg definitions

35

Community spending and personnel expenses per employee measure employee-related costs such as wages, benefits, trainings, team-building and other activities Dummy variables show

if companies take care of their employees’ CSR education by providing relevant trainings and

if they have implemented any initiatives in order to ensure protection of human rights Median value for employee CSR training is 0 both in European banks and insurance companies, indicating their low initiative and involvement in promotion CSR activities among employees However, median value for human rights policy equals to 1 and underscores companies’ engagement in ensuring protection of the rights of all people they work with

Finally, we include UN Global Compact Signatory in order to judge companies’ social responsibility by their adherence to the world's largest voluntary corporate sustainability initiative.11 The UN’s corporate citizenship initiative was launched in June 2000 with the aim

to support creation of sustainable and inclusive global economy (Kell, 2003)

Table 7 ─ Summary statistics for European Banks between 2000 and 2015

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Initiative is based on the Ten Principles on human rights, labor, environment and

anti-corruption.12 The fact that signatory to the UN Global Compact is voluntary helps different stakeholders to use it as an additional mechanism to assess general attitudes of the company towards corporate social responsibility Based on the descriptive statistics, we can see that principles have gained relatively greater popularity among banks, where signatory is more widespread than in insurance companies, although, even in banks, adherence to UN Global Compact is not absolutely prevalent and reaches only 55.49%

Financial performance can be observed by applying large set of ratios developed to measure particular aspect of interest However, we follow existing empirical researches and use four most prominent indicators To evaluate market performance of banks and insurance companies,

we apply primarily Tobin’s Q The ratio compares market value of the firm to the replacement cost of the firm's assets and is based on the hypothesis that in the long run these two amounts should be roughly equal Calculations of Tobin’s Q and other ratios explained later are based

on Bloomberg methodology and disclosed in Table 6

Table 8 ─ Summary statistics for European Insurance companies between 2000 and 2015

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As a robustness check of the results obtained on Tobin’s Q we use ratio of Market Capitalization

to Book Value employing same set of explanatory variables, controls and methods As shown

in descriptive statistics, median Tobin’s Q is close to 1 for insurance companies and exactly 1 for banks As for Market to Book ratio, on average insurance companies outperform banks and trade approximately one-and-a-half times their book value of equity, staying positive even at the minimum level, whereas in case of banks, average value of the ratio equals 1.22 and ranges widely between -26.52 and 34.50

Furthermore, we use two measures of profitability based on accounting data Return on Common Equity (ROE) reveals how much profit a company generates utilizing the money that shareholders have invested Whereas Return on Assets (ROA) shows company’s relative profitability to its total assets and illustrates management’s efficiency in generating earnings by using company’s assets Similarly to market performance ratios, in case of accounting-based indicators even though mean and median values for banks and insurance companies are somewhat close to each other, magnitude of range between minimum and maximum values is substantially greater in banks, no matter the choice of indicator (ROE or ROA)

Finally we follow Adams and Mehran (2008) and employ following control variables: natural logarithm of the book value of firm’s total assets as a measure of the company’s size; financial leverage, determined as the ratio of average assets to average equity to proxy bank’s capital structure; volatility of security prices as a measure of risk and uncertainty and finally, lagged value of ROA in the specifications, involving Tobin’s Q or Market to Book ratio as dependent variable to check robustness of the specifications

Regarding control variables for insurance companies, we exclude financial leverage due to its irrelevance for the industry and include dummy variable distinguishing results among following types of insurance: Life insurance, Property and Casualty (P&C) Insurance and Reinsurance Additionally, in order to simplify perception of how corporate governance and social responsibility indicators have developed through time across financial industry sectors under investigation, we provide comparisons of different key ratios for our sample companies within time period of 2005-2014

Figure 1 ─ Comparison of Average Development of Disclosure Scores

Source: Own calculation based on Bloomberg data

Average Governance Disclosure Score

Average Environmental Disclosure Score

Average Social Disclosure Score

Average ESG Disclosure Score

10.00 20.00 30.00 40.00 50.00 60.00

-Average Governance Disclosure Score Average Environmental Disclosure Score Average Social Disclosure Score Average ESG Disclosure Score

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Figure 1 depicts progress of ESG disclosure score together with its three constituents, particularly: Environmental, Social and Governance scores Since we don’t have exact methodology of how scores are calculated in Bloomberg system, we cannot judge precisely which factors influence advancements or reductions in the data and how However, we are still able to take a look over levels of disclosure within available time frame and across two sectors

of interest Noticeably, level of governance disclosure score is always higher than other scores

in both cases Besides, on average, insurance companies mostly disclose more extensive or better quality information regarding their governance than banks except in 2008 and 2009 Other two dimensions have not seen significant progress in insurers and basically have stayed flat, whereas banks show upward overall trend both in environmental and social disclosure Description of women participation at different levels, such as boards, management or workforce in general is presented in Figure 2 Gender balance is always kept within workforce, where share of women ranges close to 50% The same cannot be claimed about high level positions Slight upward trend can be captured in women participation on boards As for management positions, while insurance companies keep increasing number of female managers, banks preserve almost constant rate ranging between 24.64% in 2005 and 23.07% in

2014

Figure 2 ─ Comparison of Average Development of Women Participation

Source: Own calculation based on Bloomberg data

In Figure 3 we provide an insight about board independence as measured by percentage of independent directors on the boards As we can see, within the time period under consideration average percentage of independent directors doesn’t increase or decrease dramatically, however, they always stay in the majority with the share never going below 55% in case of banks and below 60% in case of insurance companies Although, as depicted in Figure 4, proportion of outside directors in boards of banks varies significantly across European countries, starting from a very low ratio of 12.32% in Romania and ending with 91.88% in Netherlands For insurance companies, range is somewhat smaller varying between 22.22% in Poland and 92.49% in Switzerland Attendance on board meetings in both sectors is similar and the figure is mostly kept close or above 90%

The last corporate governance aspects that we present are board size and number of board meetings Corresponding graphs are disclosed in Figure 5 First of all, on average, boards of our sample banks in every year between 2005-2014 slightly but still outnumber the boards of our sample insurance companies The trend can be attributed to relative complexity of banking activities or size and diversity of assets held by banks Interestingly, in both sectors we can spot tendency to reduce number of the board members.

Average % of Women in Workforce

Average % of Women in Management

Average % of Women on Board

10.00 20.00 30.00 40.00 50.00 60.00

-2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Average % of Women in Workforce Average % of Women in Management Average % of Women on Board

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Figure 3 ─ Comparison of Board Independence and Board Meeting Attendance

Source: Own calculation based on Bloomberg data

Figure 4 ─ Comparison of Board Independence across Europe

Banks

Insurance Companies

Source: Own calculation based on Bloomberg data

Difference between sectors is more evident in case of frequency of board meetings per year, where maximum average level for insurance companies doesn’t even reach the minimum value for banks Besides, the mode for the average number of meetings in case of banks equals to 15 times a year, while same figure for insurers amounts to approximately 9 meetings The underlying motive, mentioned above might also justify the need for more frequent board meetings in banks

Average % of Independent Directors

Average % of Board Meeting Attendance

20.00 40.00 60.00 80.00 100.00

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Figure 5 ─ Comparison of Board Size and Board Meetings

Source: Own calculation based on Bloomberg data

From the characteristics belonging to social responsibility category, we provide comparison of one variable, namely, percentage of employee turnover As presented in summary statistics and also noted above, our sample banks outperform insurance companies in this dimension The same can also be noticed in Figure 6, particularly for each year, average level of employee turnover is lower in absolute value for banks However, while there is a downward trend for insurance companies, for banks percentage of employee turnover keeps rising

Figure 6 ─ Comparison of Employee Turnover

Source: Own calculation based on Bloomberg data

Finally, we also inspect financial performance of our sample companies within the available time period in Figure 7 Unlike other graphs, here we employ second axis in order to measure the magnitude of average ROE Surprisingly, Tobin’s Q stays nearly constant in both cases regardless crisis periods However, other measures show significant variance and quite similar pattern Judging according to absolute value, average return on common equity has the longest magnitude, ranging between 1.77% and 15.78% in banks and between -2.18% and 17.90% in insurance companies When we compare sectors under investigation to each other within the comparable time period of 2005-2014, we can see that in terms of return on assets, insurance companies are consistently more profitable than banks on average Aside from few exceptions, the same is true for return on common equity and ratio of market capitalization to book value

Average Number of Board Meetings for the Year

Average Size of the Board

2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00

-2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Average % of Employee Turnover