Academic journal article Chicago Fed Letter

Corporate Governance at Community Banks: A Seventh District Analysis

Academic journal article Chicago Fed Letter

Corporate Governance at Community Banks: A Seventh District Analysis

Article excerpt

Community banks can be vulnerable to the same economic tensions and conflicts of interest that have compromised corporate governance at more high-profile firms over the past few years. The authors discuss their preliminary findings from a project designed to construct a systematic database on the corporate governance practices at District community banks.

Corporate managers make daily business decisions that determine how most of the resources in our economy are used, and they almost always make these decisions without consulting their stockholders, the owners of the resources. Corporate governance-one of the foundational concepts of a capitalist society-is the set of public laws and regulations, private rules, and informal practices designed to directly control or indirectly influence corporate managers to make decisions that benefit stockholders and society rather than themselves.

In the American corporate governance framework, the interests of stockholders in publicly traded firms are protected largely by three institutions. Aboard of directors, elected by stockholders, hires and monitors the activities of the firm's management. The Securities and Exchange Commission (SEC) requires the firm's management to publish regular financial statements that are reviewed and certified by outside auditors. And the stock market, made up of various investors, offers daily opinions on the health of the firm by translating public information into a higher or lower stock price. Until recently, what makes for "good" and "bad" corporate governance has chiefly been debated by financial theorists in professional journals and by financial practitioners and company directors in boardrooms. But with news of the fraudulent practices of some top managers at high-profile firms like Enron, Tyco, and WorldCom-as well as the revelations of questionable accounting practices and the appearance of excessive managerial compensation at other firms-corporate governance has become the focus of very public debate. In response to the scandals, Congress passed the Sarbanes-Oxley Act of 2002 aimed at improving the quality of audits, enhancing the financial expertise of directors, and increasing the accountability of managers at publicly traded firms. While the corporate governance environment at commercial banks can be quite different from that found in most other U.S. corporations, banks can be vulnerable to the same underlying economic tensions and conflicts of interest among managers, stockholders, and the public interest. Although very few commercial banks have failed in recent years, virtually all of these insolvencies were related to improper managerial behavior and ineffective controls (e.g., First National Bank of Keystone in 1999 and Oakwood Deposit Bank in 2002). This Chicago Fed Letter reports on a research project we are conducting at the Federal Reserve Bank of Chicago on the state of corporate governance practices at community banks in the Seventh Federal Reserve District and the relationships between those practices and bank performance.1

Corporate governance at community banks

Over 90% of the commercial banks in the U.S. can be described as "community banks." Community banking companies are small firms, most having less than $1 billion in assets, and are typically closely held.2 For community banks that are owner-operated (i.e., the top managers and their families hold the controlling interest in the bank), there may be less scope for conflicts of interest between management and stockholders because these two sets of people largely overlap. However, because these banks are not publicly traded, they do not receive potentially useful monitoring and feedback from investors in the stock and bond markets.

Owner-operated or not, all commercial banks have an additional outside monitor not present at most other corporations: federal and/or state bank supervisors. Bank supervisors regularly review banks for financial safety and soundness, internal controls, corporate governance practices, auditing policies, and compliance with numerous financial regulations. …

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