The importance of corporate governance of banks concerning the ownership in the international environment

Festić, Mejra; Črepinko, Polona; Bratina, Borut Article The importance of corporate governance of banks concerning the ownership in the international environment Naše gospodarstvo / Our Economy Provided in Cooperation with: Faculty of Economics and Business, University of Maribor Suggested Citation: Festić, Mejra; Črepinko, Polona; Bratina, Borut (2020) : The importance of corporate governance of banks concerning the ownership in the international environment, Naše gospodarstvo / Our Economy, ISSN 2385-8052, Sciendo, Warsaw, Vol. 66, Iss. 4, pp. 11-27, https://doi.org/10.2478/ngoe-2020-0020 This Version is available at: https://hdl.handle.net/10419/290480 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/4.0/ 11 The Importance of Corporate Governance of Banks Concerning the Ownership in the International Environment Mejra Festić University of Maribor, Faculty of Economics and Business, Slovenia [email protected] Polona Črepinko Frankfurt, Germany crepinko[email protected]om Borut Bratina University of Maribor, Faculty of Economics and Business, Slovenia [email protected] Abstract The analysis of the factors of corporate governance is divided into four thematic sections. In the first part corporate governance is defined as part of the broader economic context. The second part deals with the principles of corporate governance. In the third part, the relation between the index of corporate governance and individual indicators (an indicator of commitment, transparency, and disclosure, caring for partners, and control and audit) regarding ownership is defined. An analysis was undertaken for the countries of Central and Eastern Europe. A higher level of foreign ownership had a positive correlation with the corporate governance index. On the other hand, the correlation between state ownership and corporate governance index was not clear. The prevention of poor banking practices does not only lie in controlling functions, but also in the general corporate and risk-taking cultures, and the social perception of managerial roles, regardless of ownership structure. Keywords: corporate governance index, state ownership, ownership structure, corporate governance principles, board independence Introduction Sound corporate governance has become increasingly important since the economic and financial crisis that began in 2007, which exposed serious flaws in corporate governance. The crisis showed that the management tools were inefficient, especially when confronted with unexpected pressures and conflicts of interest. It was also shown that different ownership structures had different influences on governance and responsiveness during a time of crisis. NAŠE GOSPODARSTVO OUR ECONOMY Vol. 66 No. 4 ORIGINAL SCIENTIFIC PAPER RECEIVED: NOVEMBER 2019 REVISED: OKTOBER 2020 ACCEPTED: DECEMBER 2020 DOI: 10.2478/ngoe-2020-0020 UDK: 005.7:336.71:336.5- (4-191.2)(4-11) JEL: G21, G30, G32, G34, K49 Citation: Festić, M., Črepinko, P., Bratina, B. (2020). The Importance of Corporate Governance of Banks Concerning the Ownership in the International Environment. Naše gospodarstvo/Our Economy, 66(4), 11–27. DOI: 10.2478/ ngoe-2020-0020 pp. 1 1–27 2020 NAŠE GOSPODARSTVO / OUR ECONOMY Vol. 66 No. 4 / December 2020 12 This research addresses whether state ownership had a negative influence on corporate governance and, subsequently, on bank performance. Central European countries in transition privatized most state-owned companies. Different methods were used for privatization that reflected on different types of ownership structures. Ownership concentration refers to the number of shares owned by individual shareholders and institutional investors. The results of different research show that the structure of bank ownership has a strong influence on bank performance. Much research has been carried out in the last decades on corporate governance, but researchers have not been unanimous about its influence on performance, how important factors differed among countries, or what the most efficient measures and conditions for the improvement of corporate governance and, potentially, its influence on performance are. We analyzed the correlation between ownership concentration and corporate governance. Based on our research results it can be confirmed that bank ownership structure has an impact on corporate governance. This means that bank ownership structure has effects on the relationship between corporate governance and bank performance. We structured the corporate governance index, which consists of an indicator of commitment to CG, an indicator of monitoring and auditing, an indicator of the supervisory board and management structure, an indicator of stakeholder care, and an indicator of transparency and disclosure. The analysis was done on the case of Eastern European Countries and it is the contribution of our research. Literature Overview: Corporate Governance Organization for Economic Cooperation and Development (hereinafter OECD) in its Principles of Corporate Governance (2009) defined corporate governance as one of the key elements for the improvement of economic efficiency and growth, as well as for increasing investor confidence. According to the OECD definition, corporative governance is comprised of a set of relationships among the company 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 tools for attaining those objectives and monitoring performance. An effective system of corporate governance and the national economy contribute toward building an environment of trust necessary for the proper functioning of a market economy. Corporate governance is a part of a wider economic context, comprised of macroeconomic policies and market factors, namely the legal, regulatory, and institutional environment. Additionally, it incorporates business ethics and the responsibility of companies to the environmental and social development of society. Company power should be distributed according to the risk level attributed to individual stakeholders. The role of management is to adjust the interests of individual stakeholders. The supervisory board should, in addition to assessing financial statements, set up assessment mechanisms for evaluating management work and strategy implementation, as well as improving their expertise for successful functioning in boards (e.g. the audit board, risk management, remuneration, etc.). Worldwide, different systems of corporate governance are used. The Anglo-Saxon model emphasizes the interests of shareholders, whereas the models used in Europe and Japan consider the interests of all stakeholders― shareholders, employees, managers, suppliers, buyers, and the community. Jensen (1993) reported that there were four categories of mechanisms in corporate governance, aimed towards solving problems that stem from the divergence between management decisions and optimal decisions for the company, namely: (1) capital markets, i.e. mechanisms of external control; (2) legal/political/regulatory arrangements, i.e. legal and legislative mechanisms; (3) product markets, i.e. product market competition, and (4) internal control led by the supervisory board, i.e. internal control mechanisms. Shleifer and Vishny (1997) argued that the mechanisms of corporate governance were economic and legal institutions that can be altered during a political process to ensure a return on invested capital for the investors. When analyzing the mechanisms of governance, they focused mainly on incentive contracts, legal protection, and power for investors, above all with regard to the arbitrary actions of the management (protection of minority shareholder rights) and the ownership of large investors (concentrated ownership), i.e. matching of important control rights with important cash flow rights. Denis (2001) wrote about four governance mechanisms: (1) legal and regulatory mechanism, which are external to the company, (2) internal governance mechanisms, which include boards of directors, remuneration, ownership, and debt; (3) external governance mechanisms, i.e. the takeover market, and (4) product market competition. Hughes and Mester (2010) asserted that internal discipline can be established through the organizational form, ownership structure, capital structure, management boards, and the remuneration of management. External discipline is influenced by government 13 regulation and a secure network as well as through the capital market discipline (takeovers, cost of assets, the ability of stakeholders to sell shares, competition on the manager job market, external blockholders, and the competition on the product market). The Influence of ownership structure on corporate governance Central European countries in transition privatized most state-owned companies. Different methods have been used for privatization, which was reflected in different structures of ownership. Ownership concentration refers to the number of shares owned by individual shareholders and institutional investors. Large shareholders tend to seek a high level of control over company management. The same interest is shown by institutional investors (e.g. mutual funds, pension funds), which operate with large quantities of money and want to ensure appropriate yield. Large shareholders have a lively interest in monitoring the performance of the supervisory board and management. Initially, the research was focused on the idea that companies were owned by shareholders, that ownership was diversified, and that supervisors were not shareholders. During the late ′80s, research showed that many companies were owned by large shareholders (Denis & McConnell, 2003). Erkens et al. (2012) discovered that companies with larger institutional ownership operated less successfully during the 2007 crisis, noting that institutional owners had taken greater risks before the crisis. They also discovered that such companies had lower yields per share during the crisis, mainly because before the crisis independent managers and institutional shareholders encouraged managers to increase shareholder yields by making risky decisions. On the other hand, Aljifri and Moustafa (2007) asserted that institutional investors did not have an important influence on company operations, whereas state ownership did. As noted by Denis and McConnell (2003), supervisors often own a part of the company they supervise. It is reasonable to conclude that a higher overlap between ownership and supervision leads to a lower conflict of interests and, consequently, towards a higher value of the company. If owners are managers, this contributes towards the harmonization of interests between management and company owners. Higher management ownership and the fact that the interests of owners and the management are not consistent can ensure more freedom for the management and enables them to follow their interests. When the ownership is diversified and when parts of the company are owned by small shareholders, there is little incentive for spending a lot of resources on management monitoring or for influencing the decision making within the company. For many small shareholders »free-rider problem« reduces incentives for coordinating their activities. Denis and McConnell (2003) discovered that when blockholders (large shareholders) used their power, it is more likely that decisions will be made that increase the value for all shareholders. Nevertheless, blockholders also have some personal benefits. These benefits may not be harmful to other shareholders, e.g. access to influential people for large shareholders. The effect of ownership of benefits of supervision over large owners and the potential private value exploration of the company by large owners. Many studies discussed the question of whether the effects of privatization were reflected in the operating performance of companies. Megginson, Nash, and Van Randenborgh (1994) investigated 61 state-owned firms from 18 countries, which had been privatized between 1979 and 1990. The results showed that, on average, privatized companies increased their sales, became more profitable, improved their operating efficiency, and increased the number of employees. Similar findings were reported by Boubakri and Cosset (1998), who studied 79 firms from 21 developing countries between 1980 and 1992. Claessens and Djankov (1999) also reported higher productivity and growth on a sample of 6354 privatized firms from Eastern European countries during the period 1992−1995. On the other hand, Dewenter and Malatesta (2001) found that government-owned firms were considerably less profitable and efficient than privately-owned companies but did prove that privatization alone did not influence higher profitability. On the other hand, they identified that profits increase within the three years before privatization. Majumdar (1998) found that privately-owned enterprises were more efficient than state-owned or mixed-ownership enterprises. He also stated that mixed-ownership firms operated more efficiently than state-owned companies. Frydman, Gray, Hessel, and Rapaczynski (1999) argued that the influence of privatization was not the same for different types of companies and that efficiency did not improve when »insiders« were present in ownership structure, but only when external owners were present (i.e. non-employees). In a sample of Czech firms, Claessens and Djankov (1999) discovered that the more ownership structure is concentrated, the higher the company profitability and labor productivity. The influence of remuneration Remuneration is a mechanism of governance, which is based on performance. Individuals are offered bonuses, company shares, higher performance rewards, additional days off work, and other perks (see Słomka-Gołębiowska NAŠE GOSPODARSTVO / OUR ECONOMY Vol. 66 No. 4 / December 2020 14 & Urbanek, 2014). By remunerating good work, the company improves its business operations. The selection of appropriate remuneration (salary, bonuses, long-term incentives) is important because it aligns management’s interests with the interests of shareholders. The influence of transparency Firms can reveal pay packages voluntarily when there is no system of compulsory disclosure. Millar et al. (2005) found out that the ideal system of corporate governance in the 21st century does not exist, but that the most efficient systems should follow an integral approach, which encompasses aspects of different systems that are used around the world. Research findings of Millar, & Eldomiaty et al. (2005) also showed the influence of business systems on corporate governance practices, with transparency being one of the determinants of efficiency in the model of corporate governance. Institutional transparency is closely related to information revealed to company shareholders but depends on the ownership structure. The disclosure of information, i.e. transparency, depends on institutional regulation for different types of business systems, among which the efficiency of legal institutions is of the utmost importance because it sets the borders between obligatory and voluntary information disclosure. The fierce competition requires that firms respond quickly and do not wait for the new legislation in the field of disclosures, which will tell them what, where, why, how, and when to make disclosures to their shareholders. Mahoney and Mei (2009) stated that there is no proof that new disclosure requirements, which, for instance, are set in securities legislation and refer to the remuneration of management and large shareholders, reduced the asymmetry of information. Firms that disclose information regarding their operations reveal their business operations to the competition, but on the other hand, take care of their development and progress. This is, in times of fierce competition, of extreme importance. Principles for the improvement of corporate governance A healthy banking system is a precondition for a sound corporate operation and a strong stock market. According to Ribnikar (2009), therefore the state must introduce »suitable normative rules that regulate the functioning of credit institutions«. During the crisis, banks increased their dependence on the state, which ensured them liquidity and survival. Undoubtfully, the last financial crisis also shows that management and supervisory boards did not fulfill their role. Due to all shortcomings in corporate governance, even more so during the times of crisis that started in the middle of 2007, the Basel Committee on Banking Supervision decided to revise the guidelines. Sound corporate governance requires efficient legislation and regulation. Several factors including business law, stock exchange rules, and accounting standards can also influence market integrity and system stability but are frequently outside the scope of bank supervision. Improvement of corporate governance was based on 14 principles (Basel Committee on Banking Supervision, 2010). 1. The board should carry out responsibility for the bank. It approves and oversees the implementation of the bank’s strategic goals, risk strategy, corporate governance, and corporate values. 2. Board members should be and remain qualified, including through training. They should have a clear understanding of their role in corporate governance and be able to exercise sound decisions about the affairs of the bank. 3. The board should define appropriate governance practices for its work and ensure that such practices are followed and upgraded. 4. The group board is responsible for adequate corporate governance across the group and ensure there are governance policies and mechanisms appropriate to the structure, business, and risks of the group and its entities. 5. Under the direction of the board, senior management should ensure that the bank’s activities are consistent with the business strategy, risk tolerance, and policies approved by the board. 6. Banks should have an effective internal control system and a risk management function (including a chief risk officer) with sufficient authority, stature, independence, resources, and access to the board. 7. Risks should be identified and monitored on an ongoing firm-wide and individual entity basis. Bank’s risk management and internal control should keep pace with any changes to the bank’s risk profile (including its growth) and the external risk landscape. 8. Effective risk management requires robust internal communication about risks, both across the organization and through reporting to the board and senior management. 9. The board and senior management should effectively utilize the work conducted by internal audit functions, external auditors, and internal control functions. 10. The board should actively monitor and review the compensation system (design and operation) to ensure that it operates as intended. 15 11. Employee compensation should be aligned with prudent risk-taking adopted by the bank. It should be adjusted to all types of risks and symmetric with risk outcomes. Compensation payouts schedules should be sensitive to the time horizon of risks. Compensation payout (mix of cash, equity, and other forms of compensation) should be consistent with risk alignment and will likely vary across employees, depending on their position a role in the bank. 12. The board and senior management should know and understand the bank’s operational structure and the risks that it poses. 13. When a bank operates through special-purpose or in environments that impede transparency or do not meet international banking standards, its board and senior management should understand the purpose, structure, and risks of these operations and see to mitigate the identified risks. 14. The governance of the bank should be transparent to its shareholders, depositors, other relevant stakeholders, and market participants. Weaknesses of corporate governance in financial institutions are primarily related to legal protection, rule of law, conflicts of interest, and other factors. Himmelberg, Hubbard, and Love (2002) noted that the lack of legal protection for investors is reflected in the larger ownership share of the company’s capital owned by internal shareholders (i.e. there is a negative link). Dittmar, Mahrt-Smith, and Servaes (2003) claimed that companies in countries in which shareholder rights are not well-protected and have surplus cash (i.e. companies have up to twice as much money as companies in countries with good legal protection of shareholders). Research showed that better legal protection for investors is linked to the higher valuation of stock markets (La Porta, Lopez-de-Silanes, & Shleifer, 2002). Industry and companies in better legal regimes rely more on external sources of funding for their growth (La Porta, Lopez-de-Silanes, Shleifer, & Vishny, 1997). Greater security for investors also increases the desire for investors to finance and is reflected in lower costs and greater access to external funding sources (Durnev, & Kim, 2005). La Porta, Lopez-de-Silanes, Schleifer, and Vishny (1998) claimed that the legal system was a fundamentally important mechanism of corporate governance. The degree to which national law protects the rights of investors and to which laws are implemented is the most basic determinant of the direction under which corporate finance and corporate governance in the country are implemented. Gillan and others (2007) have shown that independent supervisory councils can serve as a substitute for the supervision of companies by the market and that causality takes place from the supervisory board to the choice of the provisions. Conflicts of interest Due to the systemic risks, the diversity of transactions, the diversity of financial services, and the complex structure of large financial groups, conflicts of interest in financial institutions have an even greater significance (Burkart, & Panunzi, 2001). Conflicts can arise in a variety of situations such as when exercising incompatible roles or activities, or between a financial institution and its shareholders/investors where there is cross-shareholding or a business link between an institutional investor and a financial institution in which it is investing. The role of shareholders New categories of shareholders have appeared, which seem to show little interest in the long-term governance objectives of the businesses or financial institutions in which they invest. They focus, instead, primarily on short-term (quarterly or half-yearly) goals, which encourages excessive risk-taking. Often, a director’s interests followed these short-term interests that amplified risk-taking and contributed to excessive remuneration for directors, based on the short-term share value of shares as the only performance criterion. The disinterest of shareholders concerning their financial institutions can be explained by several factors, described below (Francis et al., 2013): • Certain profitability models, based on possession of portfolios of different shares, lead to the disappearance of the concept of ownership normally associated with holding shares; • If the participation of shareholders is minimal, the cost that institutional investors would face if they wanted to actively engage in governance can dissuade them; • Conflicts of interest; • The lack of effective rights to exercise control; obstacles related to the lack of cross-border voting rights; uncertainty regarding legal concepts; and financial institutions’ disclosure of information being too complicated. When politicians serve as proprietary directors, representing large shareholders, or as executive directors, there is some evidence that board monitoring performance deteriorates (Pascual–Fuster and Crespí–Cladera, 2018). The role of supervisory authorities Supervisory authorities possess tools enabling them to intervene in the internal governance of financial institutions, NAŠE GOSPODARSTVO / OUR ECONOMY Vol. 66 No. 4 / December 2020 16 but due to financial innovations and the rapid change in the business model of these institutions, effective supervision has not been always carried out. Besides, the supervisory authorities often have failed to enforce strict eligibility criteria for members of boards of directors nor do they check if their risk management systems and internal organization were adapted to changes in their business model and financial innovations. The role of auditors Auditors have played a key role in the financial systems of corporate governance systems because the auditors assured that the financial statements prepared are credible. However, conflicts of interest can arise, because audit firms were remunerated by the very same companies who mandate them to audit their financial accounts. Financial reporting quality was higher for firms whose board’s audit committees had a greater proportion of independent directors who reside close to a firm’s headquarters than for firms whose boards consist of directors who are more geographically dispersed (Firoozi et al., 2018). Also, the importance of ownership structure for corporate governance of banks is described below: Board of directors At the heart of the origins of the 2007 crisis was the failure of financial institutions to identify, understand, and control risks for many of the following reasons: • Members of boards of directors (in particular non-executive directors) devoted neither sufficient resources nor the time to the fulfillment of their duties; • Members of boards of directors did not come from sufficiently diverse backgrounds in terms of gender, social, cultural, and educational backgrounds; • Boards of directors (in particular their chairmen) did not carry out a serious performance appraisal of their members or the board of directors as a whole; • Boards of directors were unable to ensure the appropriate risk management framework; • Boards of directors were unable to recognize the systemic nature of some risks, and thus, did not provide sufficient information to their supervisory authorities. There is also a question about the quality of appointment procedures for members of the boards of directors (Becht et al., 2002). Problems related to the efficient implementation of corporate governance in financial institutions The 2007 crisis showed that the principles of corporate governance were not efficient in the financial services sector, especially in banks. Weaknesses defined in the Green Paper were the following (European Commission 2010a, 2010b): • The existing principles of corporate governance were too broad in scope and were not sufficiently precise, giving financial institutions too much scope for interpretation; • Within the financial institution and the supervisory authority, roles and responsibilities for implementing the principles were not allocated; • The principles were based on non-binding recommendations by international organizations or the provisions of corporate governance with a lack of relevant checks and an absence of deterrent penalties. Risk management Risk management is one of the key aspects of corporate governance in financial institutions, which was not managed holistically. The main shortcomings were (Tandelilin et al. 2007): • A lack of understanding of the risks on the part of those involved; • A lack of authority on the part of the risk management function to have sufficient powers and authority to be able to curb the activities of risk-takers; • Lack of expertise in risk management. The assessment of expertise was focused only on priority risks and did not cover any other risks; • A lack of real-time information on risks. It is important to set up an efficient flow of clear and correct information on risks and to upgrade IT tools for risk management so that risks can be consolidated rapidly, allowing the evolution of group exposures to be followed up effectively in real-time. Particular responsibility for the implementation of good practices of risk management on all levels lies with the directors of financial institutions because directors must be themselves exemplary. Ownership structure Schleifer and Vishny (1997) discussed the importance of legal protection and concentrated ownership for sound corporate governance. Improved control over the largest shareholders leads to actions that increase company value and the overall position of all shareholders. On the other hand, concentrated ownership makes it possible for the largest shareholders to have discretionary power to achieve their advantages on behalf of other shareholders, which may lead to a decrease in the company value. Magalhaes et al. (2010) claimed that a concentrated ownership structure enables more efficient control, and, consequently, improves business operations. In the same manner, Caprio et al. (Caprio, Laeven, & Levine, 2007) 17 concluded that concentrated ownership represents an important mechanism for governing banks. They found that greater rights of controlling shareholders over the cash flow increase bank value. That larger concentration of ownership increases bank value was also confirmed by Li and Song (2010), while Love and Rachinsky (2007) believe that banks with highly concentrated ownership have considerably poorer corporate governance. The influence of ownership (foreign/domestic) and corporate governance (the composition of the board − external and/or foreign members) on performance (profit) and bank risks was studied by Choi and Hasan (2005). The results of their research show that there is a positive and significant correlation between foreign ownership and the operation of banks. Foreign ownership per se does not have an important influence, but the scope of foreign ownership has a positive and statistically significant influence on bank profit and risk. Banks employing a combination of increased foreign ownership and the presence of a foreign director on the board were associated with positive and significant bank performance. The influence of increased foreign ownership on bank’s interest revenues was studied by Lensink and Naaborg (2007). The results of their research show that an increase of foreign ownership has a negative and strong influence on the operation of banks, above all in terms of net interest revenues and profitability.1 Banks with a lower degree of foreign ownership are more profitable and able to raise more net interest revenues. Tandelilin et al. (2007) found out that bank ownership influences both―the relationship between corporate governance and bank operations and the relationship between corporate governance and risk management. Banks with foreign owners have a better implemented corporate governance than banks owned by the state or domestic banks that are privately owned. The authors proved the hypothesis that better corporate governance leads to improved bank performance. Barako and Tower (2007) studied the relationship between ownership structure and bank performance. The results of their research showed that a bank’s ownership structure had a strong influence on bank performance. The ownership of the board and the ownership by the state are significantly and negatively correlated with bank performance. Institutional shareholders did not significantly correlate with performance, but foreign ownership had a significant and positive correlation with bank performance. Cornett et al. (2010) found that, in the period between 1989 and 2004, state-owned banks performed with lower profits, they had core capital, and were a greater credit risk than privately-owned banks. The difference in bank performance was particularly strong in countries with greater government involvement and political corruption in the banking system. The difference between state-owned banks and privately-owned banks was lessened after the crisis in the period from 2001 to 2004. Wen (2010) found out that there was no apparent correlation between ownership structure and bank operations. He stated that state-owned commercial banks can reach a square ratio with ROE (return on equity). Spong and Sullivan (2007) found that manager ownership can improve bank performance. Boards have a positive influence on bank performance when directors had an important financial interest in the bank. The wealth and financial position of managers and directors were negatively correlated, and manager ownership was positively correlated, which was an important correlation with risk-taking. Research: Empirical Analysis of Corporate Governance and Its Influence on Bank Operations in Selected Countries Much research has been done dealing with corporate governance. However, researchers have often studied only the influence of a certain spectrum of governance. Also, research has often failed to give an extended insight into corporate governance and its influence on performance. This research mainly deals with the impact of ownership structure (Love & Rachinsky, 2007; Lskavyan & Spatareanu, 2006; Magalhaes et al., 2010; Li & Song, 2010; Choi & Hasan, 2005; Lensink & Naaborg, 2007) or the impact of the structure of management boards (Adams & Mehrana, 2003; Kyereboah-Coleman & Biekpe, 2006; Dahya et al., 2008; Li & Song, 2010; Choudhry, 2011) on corporate governance. In addition, research on remuneration, social responsibility, and corporate governance can be found in the literature. Despite the vast amount of research carried out during the last decades, researchers have not been unanimous about the influence of corporate governance on performance, nor about how important factors differ among countries, or what are the most efficient measures and conditions for the improvement of corporate governance and its influence on actual performance. 1 In the banks struggling with profitability the balance sheet was shrinked by reducing their lending to meet stricter capital requirements at the early stage of Basel III (more in Andrle et. al. 2019). There are significant differences in lending behavior between domestic and foreign banks (see, Fidrmuc & Kapounek 2019). Foreign owners have significant participation in domestic banks (when there are constraints on the supply of credit and as the external solvency of the economy and the banking sector is ensured by their negative international investment position). Banks face increasing regulatory requirements under Basel III (see Brůna & Blahová 2019). NAŠE GOSPODARSTVO / OUR ECONOMY Vol. 66 No. 4 / December 2020 18 Corporate governance variables were divided into five sets of indicators that form the so-called corporate governance index. Figure 1 shows a schematic presentation of the model of corporate governance. Performance of corporate governance was measured with indicators: return on average assets (ROAA), return on average equity (ROAE), and net interest income (NETII). 2 Research variables Table 1 shows a list of all independent variables. Based on selected parameters (variables) we designed a matrix and then, based on a review of annual reports, collected the required data. Five indicators were used in our research, namely: • Indicator of commitment to CG, • Indicator of monitoring and auditing, • Indicator of the supervisory board and management structure, • Indicator of stakeholder care, • Indicator of transparency and disclosure. Individual variables for an indicator are dummy variables, with the value 1 representing sound governance, whereas the value 0 represents poor governance. The sum of the values of variables form indicators or the so-called index of corporate governance. Subsequently, the index values were standardized. Figure 1. The model of corporate governance and its impact on bank performance3 2,3 The abbreviations are explained in Table 1. 25 References Adams, R., & Mehran, H. (2003). Is corporate governance different for bank holding companies? Federal Reserve Bank of New −142. DOI: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=387561 Aljifri, K., & Moustafa, M. (2007). The Impact of Corporate Governance Mechanisms on the Performance of UAE Firms: An Empirical Analysis. Journal of Economic & Administrative Sciences, 23(2), 71−93. DOI: https://www.emerald.com/insight/content/ doi/10.1108/10264116200700008/full/html Andrle, M., Brada, J. C., Tomšík, V., and Vlček, J. (2019). 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Preprečevanje slabih bančnih praks ni le v nadzornih funkcijah, temveč tudi v splošni korporacijski kulturi, kulturi prevzemanja tveganj in kulturi ter družbenem dojemanju vodstvenih položajev ne glede na lastniško strukturo. Ključne besede: indeks korporativnega upravljanja, državno lastništvo, lastniška struktura, načela korporativnega upravljanja, neodvisnost uprave