The Impact of Bank's Internal Governance Mechanism on Operational Loss: Evidence from Turkey

Authors

1 Department of Engineering Management, Bahcesehir University, Istanbul, Turkey

2 Coinvestion Technologies Inc., Istanbul, Turkey

Abstract

We study the impact of internal governance mechanisms on the operational risk management provided with deposit banks of Turkey as a Basel compliant representative banking system. Drawing from internal audit, internal control and risk management literature, we consider the impact of characteristics of these mechanisms on the degree of operational loss at the subcommittee level. Two factors stand out as improving the internal governance of banks. Internal governance quality improves resulting in less material operational loss with adequate staffing. Organization of the internal governance mechanisms, carefully structured control points, and sufficient reporting to senior-level management in banks ensure that banks’ shareholders experience fewer surprises. Excess funding has limited or no effect on mitigating operational loss. Characteristics are more significant for internal audit and internal control subcommittees than they are for risk management subcommittees. Results are robust when tests are repeated with aggregated data to capture potential cooperation between and contribution of the individual units.
 

Keywords

References

Agbejule, A., & Jokipii, A. (2009). Strategy, Control Activities, Monitoring, and Effectiveness. Managerial Auditing Journal, 24(6), 500–522.
Al-Matari, E. M., Al-Swidi, A., & Fadzil, F. H. B. (2014). The Effect of the Internal Audit and Firm Performance: A Proposed Research Framework. International Review of Management and Marketing, 4(1), 34–41.
Altamuro, J., & Beatty, A. (2010). How Does Internal Control Regulation Affect Financial Reporting? Journal of Accounting and Economics, 49(1–2), 58–74.
Andersen, L. B., Häger, D., Maberg, S., Næss, M. B., & Tungland, M. (2012). The Financial Crisis in an Operational Risk Management Context - A Review of Causes and Influencing Factors. Reliability Engineering & System Safety, 105, 3–12.
Andersen, T. J. (2008). The Performance Relationship of Effective Risk Management: Exploring the Firm-specific Investment Rationale. Long Range Planning, 41(2), 155–176.
Anderson, A., & Gupta, P. P. (2009). A Cross-country Comparison of Corporate Governance and Firm Performance: Do Financial Structure and the Legal System Matter? Journal of Contemporary Accounting & Economics, 5(2), 61–79.
Andres, P. D., & Vallelado, E. (2008). Corporate Governance in Banking: The Role of the Board of Directors. Journal of Banking & Finance, 32(12), 2570–2580.
Angela, C., Bisignani, R., Masala, G., & Micocci, M. (2009). Advanced Operational Risk Modelling in Banks and Insurance Companies. Investment Management & Financial Innovations, 6(3), 1-29.
Arena, M., & Azzone, G. (2009). Identifying Organizational Drivers of Internal Audit Effectiveness. International Journal of Auditing, 13(1), 43–60.
Baltagi, B. H. (2013). Econometric Analysis of Panel Data (5th). Chichester: John Wiley & Sons, Inc.
Basel Committee. (2012). The Internal Audit Function in Banks. Basel Committee on Banking Supervision, Retrieved from www.bis.org/publ/bcbs223.pdf
---------- (2011). Principles for the Sound Management of Operational Risk. Basel Committee on Banking Supervision, Retrieved from http://www.bis.org/publ/bcbs195.htm
---------- (2010). Principles for Enhancing Corporate Governance (1–42). Basel Committee on Banking Supervision, Retrieved from https://www.bis.org/publ/bcbs176.pdf
Baum, C. F. (2006). An Introduction to Modern Econometrics Using Stata. College Station, Tex: Stata Press.
Bhagat, S., & Bolton, B. (2008). Corporate Governance and Firm Performance. Journal of Corporate Finance, 14(3), 257–273.
Bond, S. R. (2002). Dynamic Panel Data Models: a Guide to Micro Data Methods and Practice. Portuguese Economic Journal, 1(2), 141–162.
BRSA. (2014). The Regulation on the Internal Systems and Internal Capital Adequacy Assessment Process of Banks (29057). Banking Regulation and Supervision Agency, Retrieved from www.bddk.org.tr
BRSA. (2006). The Regulation on the Internal Systems (26333). Banking Regulation and Supervision Agency, Retrieved from www.bddk.org.tr
Bruno, G. S. F. (2005). Approximating the bias of the LSDV Estimator for Dynamic Unbalanced Panel Data Models. Economics Letters, 87(3), 361–366.
Bun, M. J. G., & Kiviet, J. F. (2003). On the Diminishing Returns of Higher-order Terms in Asymptotic Expansions of Bias. Economics Letters, 79(2), 145–152.
Carcello, J. V., Hermanson, D. R., & Raghunandan, K. (2005). Factors Associated with U.S. Public Companies’ Investment in Internal Auditing. Accounting Horizons, 19(2), 69–84.
Chernobai, A., Jorion, P., & Yu, F. (2011). The Determinants of Operational Risk in U.S. Financial Institutions. Journal of Financial and Quantitative Analysis, 46(6), 1683–1725.
Cohen, A., & Sayag, G. (2010). The Effectiveness of Internal Auditing: An Empirical Examination of its Determinants in Israeli Organizations. Australian Accounting Review, 20(3), 296–307.
Cummins, J. D., Lewis, C. M., & Wei, R. (2006). The Market Value Impact of Operational Loss Events for US Banks and Insurers. Journal of Banking & Finance, 30(10), 2605–2634.
Dănescu, T., Prozan, M., & Dănescu, A. C. (2012). The Role of the Risk Management and of the Activities of Internal Control in Supplying Useful Information through the Accounting and Fiscal Reports. Procedia Economics and Finance, 3, 1099–1106.
Dickinson, G. (2001). Enterprise Risk Management: Its Origins and Conceptual Foundation. Geneva Papers on Risk and Insurance - Issues and Practice, 26(3), 360–366.
Erzurumlu, Y. O., & Avci, G. (2019). Audit Committee Member Characteristics and Committee Effectiveness: Evidence from Turkish Banking Sector. Working Paper, Retrieved from https://www.inderscienceonline.com/doi/abs/10.1504/IJMEF.2020.109996
Esterhuysen, J. ’nel, Van Vuuren, G., & Styger, P. (2010). The Effect of Stressed Economic Conditions on Operational Risk Loss Distributions. South African Journal of Economic and Management Sciences, 13(4), 577–492.
Flannery, M. J., & Hankins, K. W. (2013). Estimating Dynamic Panel Models in Corporate Finance. Journal of Corporate Finance, 19, 1–19.
Fraser, J. R. S., & Simkins, B. J. (2010). Enterprise Risk Management. Hoboken, N.J: Wiley.
Gendron, Y., Be´dard, J., & Gosselin, M. (2004). Getting Inside the Black Box: A Field Study of Practices in “Effective” Audit Committees. AUDITING: A Journal of Practice & Theory, 23(1), 153–171.
Growitsch, C., & Stronzik, M. (2009). Ownership Unbundling of Gas Transmission Networks – Theoretical Background and Empirical Evidence. Retrieved from 10.1.1.454.9349&rep=rep1&type=pdf
Gürbüz, O., Aybars, A., & Kutlu, Ö. (2010). Corporate Governance and Financial Performance with a Perspective on Institutional Ownership: Empirical Evidence from Turkey. Journal of Applied Management Accounting Research, 8(2), 21-37.
Hakkarainen, A., Kasanen, E., & Puttonen, V. (1997). Interest Rate Risk Management in Major Finnish Firms. European Financial Management, 3(3), 255–268.
Halperin, K. (2001). Balancing Act. Bank Systems & Technology, 38(2), 22–26.
Hanim Fadzil, F., Haron, H., & Jantan, M. (2005). Internal auditing practices and internal control system. Managerial Auditing Journal, 20(8), 844–866.
Haron, H., Jantan, M., & Pheng, E. G. (2005). Audit Committee Compliance with Kuala Lumpur Stock Exchange Listing Requirements. International Journal of Auditing, 9(3), 187–200.
Hart, O., & Moore, J. (1990). Property Rights and the Nature of the Firm. Journal of Political Economy, 98(6), 1119–1158.
Hayali, A., Dinç, Y., Sarılı, S., Dizman, A. S., & Gündoğdu, A. (2011). Importance of Internal Control System in Banking Sector: Evidence from Turkey. LCBR European Marketing Conference, Retrieved from http://www.lcbr-archives.com/proceedings-lcbr-european-marketing-conference.html
Ho, S., & Hutchinson, M. (2010). Internal Audit Department Characteristics/Activities and Audit Fees: Some Evidence from Hong Kong Firms. Journal of International Accounting, Auditing, and Taxation, 19(2), 121–136.
Hsu, C., Backhouse, J., & Silva, L. (2014). Institutionalizing Operational Risk Management: An Empirical Study. Journal of Information Technology, 29(1), 59–72.
Institute of Operational Risk. (2010). Key Risk Indicators (1–42), Retrieved from https://subscriber.riskbusiness.com/ComponentFiles/Website/InterestingReading_Filename_95.pdf
Jensen, M. C., & Meckling, W. H. (1976). Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure. Journal of Financial Economics, 3(4), 305–360.
Kiviet, J. F. (1995). On Bias, Inconsistency, and Efficiency of Various Estimators in Dynamic Panel Data Models. Journal of Econometrics, 68(1), 53–78.
Klein, A. (2002). Audit Committee, Board of Director Characteristics, and Earnings Management. Journal of Accounting and Economics, 33(3), 375–400.
Kothari, S. P., Leone, A. J., & Wasley, C. E. (2005). Performance Matched Discretionary Accrual Measures. Journal of Accounting and Economics, 39(1), 163–197.
Lam, J. (2014). Enterprise Risk Management: From Incentives to Controls. Retrieved from https://doi.org/10.1002/9781118836477
Lang, W. W., & Jagtiani, J. A. (2010). The Mortgage and Financial Crises: The Role of Credit Risk Management and Corporate Governance. Atlantic Economic Journal, 38(2), 123–144.
Li, L., & Moosa, I. (2015). Operational Risk, the Legal System and Governance Indicators: a Country-level Analysis. Applied Economics, 47(20), 2053–2072.
Marchetti, A. M. (2005). Beyond Sarbanes-Oxley Compliance: Effective Enterprise Risk Management. Hoboken, NJ: John Wiley & Sons.
Moosa, I. A. (2007). Operational Risk: A Survey. Financial Markets, Institutions & Instruments, 16(4), 167–200.
Norman, C. S., Rose, J. M., & Suh, I. S. (2011). The Effects of Disclosure Type and Audit Committee Expertise on Chief Audit Executives’ Tolerance for Financial Misstatements. Accounting, Organizations and Society, 36(2), 102–108.
Penrose, E. T. (1995). The Theory of the Growth of the Firm (3rd). New York: Oxford University Press.
Plumlee, M., & Yohn, T. L. (2010). An Analysis of the Underlying Causes Attributed to Restatements. Accounting Horizons, 24(1), 41–64.
Pratt, J. W., & Zeckhauser, R. (1985). Principals and Agents: the Structure of Business. Boston: Harvard Business School Press.
Prawitt, D. F., Smith, J. L., & Wood, D. A. (2009). Internal Audit Quality and Earnings Management. The Accounting Review, 84(4), 1255–1280.
Ratcliffe, T. A. (2009). Understanding Internal Control and Internal Control Services (9). New York: American Institute of Certified Public Accountants.
Reinhard, L., & Li, S. (2010). A Note on Capital Structure Target Adjustment – Indonesian Evidence. International Journal of Managerial Finance, 6(3), 245–259.
Roodman, D. (2009). A Note on the Theme of Too Many Instruments. Oxford Bulletin of Economics and Statistics, 71(1), 135–158.
Sarens, G., De Beelde, I., & Everaert, P. (2009). Internal Audit: A Comfort Provider to the Audit Committee. The British Accounting Review, 41(2), 90–106.
Tseng, C. Y. (2007). Internal Control, Enterprise Risk Management and Firm Performance (Unpublished Doctoral Dissertation). University of Maryland, Baltimore.
Wang, T., & Hsu, C. (2013). Board Composition and Operational Risk Events of Financial Institutions. Journal of Banking & Finance, 37(6), 2042–2051.
Williamson, O. E. (1996). Economic Organization: The Case For Candor. Academy of Management Review, 21(1), 48–57.
Williamson, O. E. (1981). The Economics of Organization: The Transaction Cost Approach. American Journal of Sociology, 87(3), 548–577.
Yurtsever, G. (2008). Internal Control on Banking System. İstanbul: Turkish Banking Association.
Zain, M. M., Subramaniam, N., & Stewart, J. (2006). Internal Auditors’ Assessment of their Contribution to Financial Statement Audits: The Relation with Audit Committee and Internal Audit Function Characteristics. International Journal of Auditing, 10(1), 1–18.
Ziegenfuss, D. D., Myers, P. M., & Talley, W. K. (2006). Determinants of Internal Audit Function Performance. Dean’s Research Seminar, Old Dominion University, Retrieved from https://images.slideplayer.com/15/4791936/slides/slide_1.jpg
Iranian Economic Review
Volume 25, Issue 4
December 2021
Pages 603-622

Files

Share

How to cite

Statistics