TAILIEUCHUNG - CORPORATE GOVERNANCE AND BANKING REGULATION

Adverse selection arises from different borrowers having different probabilities of repayment. Therefore, to maximise expected return, the bank would like to only lend to borrowers with a high probability of repayment. In order to determine who the good borrowers are, the bank can use the interest rate as a screening device. Unfortunately those who are willing to pay high interest rates may be bad borrowers because they perceive their probability of repayment to be low. Therefore, as interest rates rise, the average “riskiness” of borrowers increases, hence expected profits are lower. The behaviour of the borrower. | CORPORATE GOVERNANCE AND BANKING REGULATION WORKING PAPER 17 Kern Alexander Cambridge Endowment for Research in Finance University of Cambridge Trumpington Street Cambridge CB2 1AG Tel 44 0 1223-760545 Fax 44 0 1223-339701 Ka231@ June 2004 This Working Paper forms part of the CERF Research Programme in International Financial Regulation 1 Abstract The globalisation of banking markets has raised important issues regarding corporate governance regulation for banking institutions. This research paper addresses some of the major issues of corporate governance as it relates to banking regulation. The traditional principal-agent framework will be used to analyse some of the major issues involving corporate governance and banking institutions. It begins by analysing the emerging international regime of bank corporate governance. This has been set forth in Pillar II of the amended Basel Capital Accord. Pillar II provides a detailed framework for how bank supervisors and bank management should interact with respect to the management of banking institutions and the impact this may have on financial stability. The paper will then analyse corporate governance and banking regulation in the United Kingdom and United States. Although UK corporate governance regulation has traditionally not focused on the special role of banks and financial institutions the Financial Services and Markets Act 2000 has sought to fill this gap by authorizing the FSA to devise rules and regulations to enhance corporate governance for financial firms. In the US corporate governance for banking institutions is regulated by federal and state statute and regulation. Federal regulation provides a prescriptive framework for directors and senior management in exercising their management responsibilities. US banking regulation also addresses governance problems in bank and financial holding companies. For reasons of financial stability the paper argues that national banking law and regulation should

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