Ma sa r yk Un iv e rsi t y Faculty of Economics and Administration Field of study: Finance CORPORATE GOVERNANCE AND SOCIAL RESPONSIBILITY IN BANKING AND INSURANCE Diploma Thesis Thesis Supervisor: Oleg DEEV Author: Nino KHAZALIA Brno, 2016 Nam e and surn am e of t he aut hor: M ast er’s t hesi s t i t l e: Ni no Khaz al i a C orporat e Gov ernan ce and S oci al R esponsi bi l i t y i n B a nki ng and Insu ranc e Depart m ent : Finance M ast er’s t hesi s supe rvi sor: Oleg Deev M ast er’s t hesi s dat e : 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 Declaration "I hereby declare that I worked out the Diploma Thesis “Corporate Governance and Social Responsibility in Banking and Insurance”, under the supervision of Oleg Deev, and that I stated in it all the literary resources and other specialist sources used according to legislation, internal regulations of Masaryk University and internal management acts of Masaryk University and the Faculty of Economics and Administration" Brno, 13.05.2016 Author’s signature Acknowledgement I would first like to thank my thesis supervisor Oleg Deev for the tremendous support, patience, motivation, enthusiasm and helpful recommendations I would also like to thank my family and friends for providing me with unconditional support and continuous encouragement throughout my years of study at Masaryk University CONTENTS Introduction .8 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 Corporate Social Responsibility .26 2.1 Definition and importance 26 2.2 Empirical evidence on the effects of CSR on financial institutions’ performance 27 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 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 longrung 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 longterm 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 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/annurevfinancial-021113-074421 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 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 presents review of the literature on corporate social responsibility and its impact on financial performance Chapter introduces the data, methodology used to estimate relations under consideration and discusses corresponding empirical results CORPORATE GOVERNANCE 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 & BrajovicBratanovic, 2009) Gup (2007) distinguishes two different models of corporate governance in banks: The AngloAmerican 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); 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3529–3547 doi:10.1016/j.jbankfin.2013.04.023 74 LIST OF TABLES Table – Comparison of corporate governance systems 11 Table ─ Recent studies on board size and bank performance .20 Table ─ Recent studies on board independence and bank performance .21 Table ─ Recent studies on corporate governance in insurance companies 24 Table ─ Recent studies on CSR and financial institutions’ performance 30 Table ─ List and definitions of chosen variables 33 Table ─ Summary statistics for European Banks between 2000 and 2015 35 Table ─ Summary statistics for European Insurance companies between 2000 and 2015 36 Table ─ Preliminary Fixed Effects Regressions of Tobin’s Q on Corporate Governance and Social Responsibility Indicators Together and Separately .45 Table 10 ─ Fixed Effects Regressions of Tobin’s Q on Corporate Governance and Social Responsibility Indicators 47 Table 11 ─ Preliminary Fixed Effects Regressions of Market Capitalization to Book Value on Corporate Governance and Social Responsibility Indicators Together and Separately 48 Table 12 ─ Fixed Effects Regressions of Market Capitalization to Book Value on Corporate Governance and Social Responsibility Indicators 51 Table 13 ─ Preliminary Fixed Effects Regressions of ROE and ROA on Corporate Governance and Social Responsibility Indicators Together and Separately 52 Table 14 ─ Fixed Effects Regressions of ROE on Corporate Governance and Social Responsibility Indicators 53 Table 15 ─ Fixed Effects Regressions of ROA on Corporate Governance and Social Responsibility Indicators 54 Table 16 ─ Preliminary Regressions of Tobin’s Q and Market Capitalization to Book Value on Corporate Governance and Social Responsibility Indicators Together and Separately 56 Table 17 ─ Fixed Effects Regressions of Tobin’s Q on Corporate Governance and Social Responsibility Indicators 57 Table 18 ─ Fixed Effects Regressions of Market Capitalization to Book Value on Corporate Governance and Social Responsibility Indicators 58 Table 19 ─ Preliminary Regressions of ROE and ROA on Corporate Governance and Social Responsibility Indicators Together and Separately 60 Table 20 ─ Fixed Effects Regressions of ROE on Corporate Governance and Social Responsibility Indicators 61 Table 21 ─ Random Effects Regressions of ROA on Corporate Governance and Social Responsibility Indicators 62 75 LIST OF FIGURES Figure ─ Comparison of Average Development of Disclosure Scores 37 Figure ─ Comparison of Average Development of Women Participation 38 Figure ─ Comparison of Board Independence and Board Meeting Attendance 39 Figure ─ Comparison of Board Independence across Europe 39 Figure ─ Comparison of Board Size and Board Meetings 40 Figure ─ Comparison of Employee Turnover 40 Figure ─ Comparison of Financial Performance 41 76 LIST OF ABBREVIATIONS AIM AMF Assonime BCBS BHC BIS CAC CED CEO CER CFP Consob CRA CRO CSP CSR ESG EU FDIC FE GDP GLS G-SIB GUM LSE M&A M/B MTA MTF OECD OLS OTS P&C RA ROA ROE SBF SUR TTS U.S UK UN WBCSD Alternative Investment Market Autorité des Marchés Financiers l’Associazione fra le Società italiane per Azioni Basel Committee on Banking Supervision Bank Holding Company Bank for International Settlements Cotation Assistée en Continu Committee for Economic Development Chief Executive Officer Corporate Environmental Responsibility Corporate Financial Performance Commissione Nazionale per le Società e la Borsa Community Reinvestment Act of 1977 Chief Risk Officer Corporate Social Performance Corporate Social Responsibility Environmental, Social, and Governance European Union Federal Deposit Insurance Corporation Fixed Effects Gross Domestic Product Generalized Least Squares Global Systemically Important Banks General Unrestricted Model London School of Economics Mergers and Acquisitions Market Capitalization to Book Value Mercato Telematico Azionario Multilateral Trading Facility Organisation for Economic Co-operation and Development Ordinary Least Squares One-Tier Structure Property and Casualty Random Effects Return on Assets Return on Common Equity Société des Bourses Françaises Seemingly Unrelated Regression Two-Tier Structure United States of America United Kingdom United Nations World Business Council for Sustainable Development 77 LIST OF APPENDICES Appendix ─ Correlation Matrices Appendix ─ Corporate Governance and Social Responsibility in Five Largest Banks and Insurance Companies 78 Appendix ─ Correlation Matrices Table 1.1 ─ Correlation matrix for banks between 2000-2015 ESG Score Women on Board Ind Dir Unitary/Two tier Board meetings Board Size CEO Duality En Int per Emp Emp Turnover Commun Spending Emp CSR Training Hum Rights Pol Per Exp Per Emp UN Gl Comp Sign Tobin's Q 1.00 0.18 1.00 0.26 0.17 1.00 (0.08) (0.05) (0.41) 1.00 (0.13) (0.14) (0.15) 0.20 1.00 0.29 (0.08) (0.10) 0.04 (0.14) 1.00 0.09 (0.12) (0.01) 0.08 (0.11) 0.03 1.00 0.14 (0.16) 0.29 (0.23) 0.04 0.10 0.09 1.00 0.02 0.18 0.07 0.08 (0.13) (0.08) (0.04) (0.13) 1.00 (0.02) (0.14) (0.02) (0.14) (0.15) (0.31) 0.03 (0.07) 0.20 1.00 0.33 0.01 0.00 0.01 (0.09) 0.15 0.18 0.00 0.04 (0.08) 1.00 0.60 0.12 (0.09) 0.07 0.13 0.23 0.10 0.13 (0.01) (0.25) 0.17 1.00 0.03 0.01 0.02 (0.13) (0.07) (0.30) 0.08 (0.09) 0.17 0.93 (0.10) (0.14) 1.00 0.56 0.21 (0.04) (0.01) (0.10) 0.30 0.12 0.13 0.06 (0.18) 0.27 0.63 (0.11) 1.00 (0.15) 0.07 (0.05) 0.12 0.01 (0.01) 0.08 0.05 0.06 0.23 0.29 1.00 ROA (0.10) (0.03) (0.01) (0.11) 0.07 (0.13) 0.05 0.08 0.09 0.07 0.02 0.05 0.06 0.04 0.36 0.17 0.60 1.00 Total Assets 0.29 0.17 0.11 (0.12) (0.15) (0.09) 0.07 (0.11) 0.42 0.86 0.01 0.06 0.41 0.16 (0.00) 0.04 0.04 (0.01) 1.00 Volatility 0.04 (0.07) (0.13) 0.22 0.10 0.07 (0.05) (0.13) 0.01 0.01 0.04 (0.03) (0.01) (0.09) (0.01) (0.17) (0.28) (0.14) 0.03 1.00 Leverage 0.06 0.02 (0.05) 0.03 0.02 0.11 (0.03) (0.04) 0.24 (0.17) 0.11 0.00 (0.03) 0.03 (0.03) (0.03) 0.05 (0.11) 0.11 0.13 1.00 Leverage 0.03 Volatility (0.12) Total Assets (0.01) ROA 0.02 ROE 1.00 (0.11) Market/Book 0.51 ROE Tobin's Q 1.00 (0.03) UN Gl Comp Sign (0.02) (0.01) Per Exp Per Emp (0.02) (0.11) Hum Rights Pol (0.10) (0.12) Emp CSR Training (0.07) (0.04) Commun Spending (0.10) 0.08 Emp Turnover 0.06 0.02 En Int per Emp (0.07) 0.07 CEO Duality 0.09 (0.26) Board Size (0.21) (0.09) Board meetings (0.02) (0.14) Unitary/Two tier (0.10) 0.05 Ind Dir 0.00 (0.08) Women on Board (0.14) (0.17) ESG Score (0.14) Market/ Book Data are obtained from Bloomberg database Data are obtained from Bloomberg database 1.00 0.04 1.00 Type of Ins 1.00 0.04 0.18 Volatility 1.00 (0.20) (0.33) (0.24) Total Assets 1.00 0.70 (0.01) (0.46) (0.07) ROA 1.00 0.36 0.29 (0.08) (0.22) 0.01 ROE 1.00 0.69 0.34 0.53 (0.19) (0.22) (0.17) Market/ Book 1.00 (0.03) (0.02) (0.02) (0.12) 0.45 (0.06) (0.12) Tobin’s Q 1.00 0.63 0.01 0.02 0.02 (0.13) 0.35 (0.09) (0.00) UN Gl Comp Sign 1.00 0.12 0.16 (0.18) (0.16) (0.09) (0.08) 0.06 (0.00) (0.13) Hum Rights Pol 1.00 (0.02) 0.16 0.38 0.11 0.27 0.01 (0.11) 0.50 (0.14) 0.05 Emp CSR Training 1.00 0.28 (0.04) 0.19 0.12 0.04 0.09 (0.10) (0.11) 0.45 0.13 0.39 Commun Spending 1.00 (0.15) (0.10) 0.24 0.03 0.12 (0.37) (0.41) (0.19) (0.17) 0.10 0.03 (0.33) Emp Turnover 1.00 0.02 (0.03) 0.18 0.00 0.07 0.18 (0.14) (0.12) 0.05 0.17 0.01 (0.03) (0.22) En Int per Emp 1.00 0.15 0.11 (0.05) 0.26 0.33 0.17 0.25 (0.18) (0.14) (0.12) (0.26) 0.16 0.02 (0.11) CEO Duality 1.00 0.08 (0.09) 0.07 0.33 0.32 0.12 0.20 0.16 0.00 0.09 0.03 (0.06) 0.16 0.19 0.15 Board Size 1.00 0.27 0.10 0.23 (0.28) 0.09 0.10 (0.05) (0.22) (0.11) (0.14) (0.07) (0.06) (0.06) 0.01 0.14 0.27 Board meetings 1.00 (0.36) (0.06) (0.43) 0.07 0.28 0.01 0.05 (0.13) (0.11) (0.17) (0.34) (0.27) (0.18) (0.09) (0.04) 0.01 (0.07) Ind Dir 1.00 (0.03) 0.11 0.11 (0.24) (0.09) (0.13) (0.03) 0.16 (0.11) 0.13 0.17 0.33 0.25 0.12 0.16 0.15 (0.17) 0.01 Women on Board 1.00 0.08 (0.11) 0.00 0.24 0.33 0.06 0.24 0.35 0.32 0.32 0.66 0.55 (0.23) (0.14) (0.12) (0.29) 0.47 (0.05) 0.04 ESG Score ESG Score Women on Board Ind Dir Unitary/ Two tier Board meetings Board Size CEO Duality En Int per Emp Emp Turnover Commun Spending Emp CSR Training Hum Rights Pol UN Gl Comp Sign Tobin’s Q Market/ Book ROE ROA Total Assets Volatility Type of Ins Unitary/ Two tier Table 1.2 ─ Correlation matrix for insurance companies between 2000-2015 Appendix ─ Corporate Governance and Social Responsibility in Five Largest Banks and Insurance Companies Table 2.1 ─ Corporate Governance and Social Responsibility in Five Largest Banks 30 90 80 25 70 20 60 50 15 40 10 30 20 10 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2006 2007 2008 2009 2010 2011 2012 2013 2014 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 BARCLAYS PLC BNP PARIBAS Number of Board Meetings for the Year CREDIT AGRICOLE Size of the Board Employee Turnover % DEUTSCHE BANK-RG % Women on Board Data are obtained from Bloomberg database Magnitudes of variables computed in percentages are measured on the secondary axis HSBC HLDGS PLC % Independent Directors Table 2.2 ─ Corporate Governance and Social Responsibility in Five Largest Insurance Companies 30 90 80 25 70 20 60 50 15 40 10 30 20 10 Allianz Aviva Number of Board Meetings for the Year AXA Size of the Board Employee Turnover % Legal & General % Women on Board Data are obtained from Bloomberg database Magnitudes of variables computed in percentages are measured on the secondary axis Prudential PLC % Independent Directors 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2014 2013 2012 2011 2010 2009 2007 2006 2014 2013 2012 2011 2010 2009 2008 2007 2006 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2014 2013 2012 2011 2010 2009 2008 2007 2006