corporate governance and risk management the role of risk

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Corporate governance and risk management: The role of risk

management and compensation committees

Ngoc Bich Tao, Marion Hutchinson

School of Accountancy, Queensland University of Technology, Australia

a r t i c l e i n f o

Article history:

Received 24 February 2012

Revised 4 February 2013

Accepted 6 February 2013

Available online 4 April 2013

Keywords:

Corporate governance

Risk management

Compensation committee

Risk management committee

Firm performance

a b s t r a c t

This paper examines the role of compensation and risk committees in managing and mon-

itoring the risk behaviour of Australian financial firms in the period leading up to the global

financial crisis (20062008). This empirical study of 711 observations of financial sector

firms demonstrates how the coordination of risk management and compensation commit-

tees reduces information asymmetry. The study shows that the composition of the risk and

compensation committees is positively associated with risk, which, in turn, is associated

with firm performance. More importantly, information asymmetry is reduced when a

director is a member of both the risk and compensation committees which moderate the

negative association between risk and firm performance for firms with high risk.

2013 Elsevier Ltd. All rights reserved.

1. Introduction

Recent corporate scandals of financial institutions worldwide have raised considerable concern among investors and reg-

ulators. Regardless of whether the global financial crisis resulted from excessive risk-taking ( Kashyap et al., 2008), or is

attributable to the increasing levels of risk faced by firms (Raber, 2003), both views identify risk as the major contributor,

and highlight the importance of an appropriate corporate governance structure for managing risk. Consequently, the focus

of this paper is on identifying factors associated with monitoring risk in the Australian financial sector. The financial sector in

Australia is the largest industry sector based on capitalisation. As of June 2011 the 288 companies in the financial sector of

Australia have a market capitalisation of AU$455.7 billion. The financial sector consists of trading and investment banks, as-

set managers, insurance companies, real estate investment trusts (REIT) and other providers of financial services. In Austra-

lia, employers in all sectors are required to contribute to a compulsory employee superannuation scheme.1 This means

Australia has the 4th largest pension fund pool in the world, creating enormous opportunities for banks, asset management,

financial planning and insurance companies.

2

Consequently, the governance practices of this sector are important to the eco-nomic welfare of Australia.

Agency theory suggests that there are divergent risk preferences of risk-neutral (diversified) shareholders and risk-averse

managers which necessitates monitoring by the board (Jensen and Meckling, 1976; Subramaniam et al., 2009). Conse-

quently, without monitoring, risk-averse managers may reject profitable (but more risky) projects which are attractive to

shareholders who prefer the increased return from the higher level of risk. Excessive managerial risk-taking is not considered

1815-5669/$ - see front matter 2013 Elsevier Ltd. All rights reserved.http://dx.doi.org/10.1016/j.jcae.2013.03.003

Corresponding author. Address: Queensland University of Technology, School of Accountancy, P.O. Box 2434, Brisbane, Australia. Tel.: +61 7 3138 2739;

fax: +61 7 3138 1812.

E-mail address: [email protected](M. Hutchinson).1 Employers are required by law to pay an additional amount based on a proportion of an employees salaries and wages (currently 9%) into a complying

superannuation fund.2 http://www.asx.com.au/documents/research/financial_sector_factsheet.pdf.

Journal of Contemporary Accounting & Economics 9 (2013) 8399

Contents lists available at SciVerse ScienceDirect

Journal of ContemporaryAccounting & Economics

j o u r n a l h o m e p a g e : w w w . e l s e v i e r . c o m / l o c a te / j c a e
http://dx.doi.org/10.1016/j.jcae.2013.03.003mailto:[email protected]://www.asx.com.au/documents/research/financial_sector_factsheet.pdfhttp://dx.doi.org/10.1016/j.jcae.2013.03.003http://www.sciencedirect.com/science/journal/18155669http://www.elsevier.com/locate/jcaehttp://www.elsevier.com/locate/jcaehttp://www.sciencedirect.com/science/journal/18155669http://dx.doi.org/10.1016/j.jcae.2013.03.003http://www.asx.com.au/documents/research/financial_sector_factsheet.pdfmailto:[email protected]://dx.doi.org/10.1016/j.jcae.2013.03.003http://-/?-http://-/?-http://-/?-


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problematic for nonfinancial firms because one firms failure will not affect a diversified investors portfolio in any direc-

tional way.Pathan (2009)suggests that bank shareholders prefer excessive risk due to the moral hazard problem of limited

liability and the associated convex pay-off (Jensen and Meckling, 1976).3 However,Gordon (2011)suggests that this may not

be the case in the financial sector. The failure of a systemically important financial firm increases the likelihood that other finan-

cial firms will fail due to the cascading effects from the contraction of the financial sector such as occurred in the Global Finan-

cial Crisis. Consequently, monitoring excessive risk-taking by management is particularly important in the financial sector. The

risk management committee and the compensation committee are both responsible for monitoring and oversight of firms risk-

related activities. Thus, a compensation or risk committee that reduces excessive risk-taking and the probability of the failure of

a systemically important financial firm will benefit diversified shareholders.

This paper investigates the association between the risk management committee (RC) and compensation committee (CC)

and the risk and performance level of financial firms. We suggest that certain characteristics of committees (size, composi-

tion and function) reflect the committees motivation and ability to increase risk-taking that is aligned with shareholders

interests. The paper therefore predicts a positive association between risk and the structure of the RC and CC. Further, we

suggest that firms experiencing increasing levels of risk require a RC and CC that manage and monitor risk to ensure a po-

sitive association between risk and performance. The results of the research show that RC and CC characteristics have an

important role in the risk level of the firm. Using a principal components analysis we derive a factor score for the character-

istics of the committees and use beta as the measure of risk. 4

This paper also investigates the risk and performance relationship when directors occupy positions on both committees

(hereafter, dual membership). The study finds a positive association between risk and performance when committee mem-

bers simultaneously serve on the RC and CC. This result demonstrates lower information asymmetry when directors have

responsibilities in both committees as they are able to oversee the association between the firms risk exposure and the pro-

portion of risk-taking incentives in compensation packages. Subsequently, more informed decisions result in a positive asso-

ciation between risk and performance. The result persists when controlling for endogeneity.

This paper contributes to the literature in several ways. To our knowledge, no other study has empirically tested whether

directors dual-membership on the RC and CC co-ordinates monitoring the risk level of the firm with monitoring the riskiness

of compensation packages. Literature on dual committee membership is limited to theory and minimalanalysis (Chandar et al.,

2012; Hoitashand Hoitash,2009; Lauxand Laux, 2009). Co-ordination betweenRC and CC functions reduces informationasym-

metries which affect firm performance. While some research establishes that board committees improve the performance of

the firm (e.g., Klein, 1998), there is little research into these committees in Australian companies, and in particular their effect

on risk and firm performance. Unlike the US where establishing an audit, nomination and compensation committee is man-

dated, there is no mandatory requirement for companies to establish committees in Australian firms (apart from Listing rule

12.7).5 Instead, corporations canchoose notto complywith therecommendationsas long as they can justify any non-compliance.

Consequently, Australia provides an interesting setting to explore the costs and benefits of board sub-committees.

Further, financial sector firms (banks, diversified financial companies, insurance and real-estate investment trusts) have

explicitly been excluded from previous research due to the higher level of risk when compared to other firms (Wallace and

Kreutzfeldt, 1991) which causes generalisability and transferability problems. In that regard the Australian Prudential Reg-

ulation Authority (APRA, 2009) has implemented a framework which regulates financial institutions (see Appendix A). Pru-

dential Standard APS 510 outlines the skills, knowledge and experience requirements for directors involved in risk

management.6

In recent years, many banks and financial institutions have been widely criticised for paying excessive bonuses to some

executive directors and senior management at a time when the world is suffering the consequences of a global financial cri-

sis, said to be a result of irresponsible risk-taking by financial institutions (Pathan, 2009). This study contributes to the lit-

erature as there is a paucity of research on whether the compensation and risk management practices of the financial sector

are associated with the level of risk and related return. Given that the adoption of RC and CC by Australian companies is vol-

untary, it is not surprising that the influence of these committees has not been fully explored.

The paper proceeds as follows. In Section2 we review the relevant literature and present a number of hypotheses. Sec-

tion 3 describes the research methodology and Section4 provides the results of the analysis. The final section provides a

summary and conclusion.

2. Background and hypothesis development

Financial firms have become large, complex organisations involving significant delegation of decision-making and risk-

taking responsibility. Consequently, it is difficult to design internal systems that ensure delegated decision-making

outcomes align principal and agents divergent goals (Devis, 1999). Although information asymmetries can be found in all

3 Pathan (2009)also suggests that poor bank governance is more catastrophic than non-bank firms as bank failure has more significant costs.4 We exclude committee size from the principal components analysis as research finds inconclusive results on the effects of board or committee size.5 Listing rule 12.7 requires companies included in the All Ordinaries Index to have an audit committee, whereas companies in the top 300 of the index are

required to have their audit committee constituted in terms of recommendations provided by the ASX CGC. These recommendations are on the composition,

operation and responsibilities of the audit committee.6

. . .

the requirement for directors, collectively, to have the necessary skills, knowledge and experience to understand the risks of regulated institution, including itslegal and prudential obligations, and to ensure that the regulated institution is managed in an appropriate way taking into account these risks (APS 510: 3).

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sectors, Andres and Vallelado (2008) suggest that information asymmetries in the financial sector may be stronger due to

business complexity and the idiosyncratic nature of the sector. For example, information asymmetry in the banking industry

is due to complex transactions including, the difficulty in determining the quality of loans, opaque financial engineering,

complicated financial statements, investment risk is easily modified, or perquisites are easier for managers to obtain (Levine,

2004). Within a framework of limited competition, intense regulation, and higher informational asymmetries the board be-

comes a key mechanism to monitor managers behaviour and to give advice on risk management, strategy identification and

implementation (Andres and Vallelado, 2008).

According to agency theory, the board of directors is considered a vital element of corporate governance based on the

premise that the characteristics of the board members determines the boards ability to monitor and control managers, pro-

vide information and counsel to managers, monitor compliance with applicable laws and regulations, and link the corpora-

tion to the external environment (Carter et al., 2010). Subsequently the majority of the existing literature focuses on

investigating the boards characteristics such as its composition and size.

However,John and Senbet (1998)argue that a boards internal administrative structure is of more importance in measur-

ing a boards efficacy. The board of directors delegates some of its authority to specific committees which are responsible for

a particular area in which the committee members specialise. In Australia, the ASX CGC has set guidelines concerning risk

management practices within Australian publicly listed companies, laying the responsibility with boards of directors ( ASX

CGC, 2007). In particular, these guidelines recommend that corporations establish a compensation committee (CC) and a risk

management committee (RC) as a means of improving corporate governance, and in particular, risk management.

Board sub-committees are established to assist the board perform its role, particularly with increased responsibilities and

pressures placed on the board. Compensation and risk committees are important corporate governance mechanisms that

protect shareholders interests by providing independent oversight of various board activities ( Harrison, 1987). Harrison

(1987)suggests that a board sub-committee enables directors to devote attention to specific areas of responsibilities, brings

legitimacy and accountability to corporations and also improves directors participation in board and committee meetings.

Research also suggests that separate committees have more influence over corporate performance ( Klein, 1998), corporate

strategy (Vance, 1983) and reducing agency problems (Davidson et al., 1998) than the entire board. Consequently, commit-

tees are important in firms where agency costs are high, for example, high risk, leverage, complexity and large size. Further-

more, agency theory suggests that characteristics such as its independence and an independent chairperson are potential

factors influencing committee effectiveness (Bradbury, 1990; Carson, 2002).

2.1. Risk monitoring in the financial sector: the risk and compensation committee

The risk management committee monitors the level of risk the firm is exposed to while keeping in mind the desire to

maximise returns. The RC advises the board on the firms management of the current risk exposure and future risk strategy

(Walker, 2009). The compensation committee oversees remuneration practices which are designed to attract and retainemployees. Remuneration practices are also designed to provide incentives for risk adverse managers to assume the level

of risk that risk neutral shareholders would tolerate. A major challenge for firm risk management is designing compensation

contracts which motivate managers to act in accordance with the risk preferences of shareholders while maintaining an

appropriate level of risk for the firm (Murphy, 2000).

According to signalling theory (Certo, 2003) organisations disclose good corporate governance practices, such as commit-

tee formation, to create a favourable image in the market. This, in turn, minimises any potential firm devaluation by inves-

tors or maximises the potential for firm value enhancement. However,Menon and Williams (1994)argue that in many cases

committees may be formed to promote the appearance of good corporate governance without serving any useful purpose for

the organisation. Consequently, it is the competence (not merely the existence) of the committees which is critical to the

success of the firm (Akhigbe and Martin, 2006). Committee directors specific knowledge of the complexity of the financial

sector enables them to monitor and advise on their area of responsibility.

Factors determining the governance efficacy of the compensation, risk and audit committees are similar as they are mon-

itoring committees of the board. This research examines the governance efficacy of the RC and CC based on four character-istics which were identified by Xie et al. (2003) as contributing to audit committee effectiveness.7 First, to fulfil their

monitoring role, the committees need to be independent of company management. The ASX CGC recommends that the com-

pensation committee should consist of a majority of independent directors ( ASX CGC, 2007, p. 35). This recommendation re-

flects an agency theory perspective that independent directors are more representatives of shareholders and therefore better

contribute to the provision of independent monitoring of management ( Fama and Jensen, 1983; Jensen and Meckling, 1976;

Pincus et al., 1989).

Second, the RC and CC need to contain members with expertise in business. Monitoring by the RC and CC requires that the

committee members contribute sufficient expertise, judgement and professional scepticism to the monitoring process

(Raber, 2003). A further measure of expertise may be the length of service (tenure). We suggest that directors ability to mon-

itor risk is related to length of service on the board or in the financial industry. Third, the RC and CC should meet often

enough to ensure that relevant issues are considered in a timely and effective manner. Committees are extensions of the

board of directors; consequently, directors frequently lack time to carry out their duties ( Lipton and Lorsch, 1992). More

7 Similar to the audit committee, the RC and CC are monitoring committees which specifically handle agency issues ( Xie et al., 2003).

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frequent meetings allow potential problems to be identified, discussed and avoided. Therefore, frequent meetings are likely

to result in better monitoring of risk. Finally, the size of the compensation and risk committees may arguably have an impact

on their monitoring function.

Risk or compensation committee monitoring (measured by committee size, independence, experience and activity) is ex-

pected to reduce managers risk adverse behaviour.Pathan (2009)suggests that strong board monitoring is positively asso-

ciated with bank risk-taking based on the view that bank shareholders have incentives for more risk and finds that small

bank boards are positively associated with more risk-taking. Governance variables (board independence and shareholder

protection) are negatively associated with risk, suggesting that more stringent monitoring reduces bank risk-taking.

As the role of the RC is to monitor firm risk levels we expect that an effective RC, as determined by the composition of the

RC, will be associated with maintaining risk levels commensurate with the firms risk appetite. In other words, we do not

expect a positive association between RC composition and firm risk. In contrast, agency theory infers that the role of the

CC is to design compensation contracts that induce risk-averse managers to undertake all risky projects that are represen-

tative of shareholders interests. Consequently, there will be a positive association between CC characteristics and firm risk

because research suggests that shareholders prefer more risk (Jensen and Meckling, 1976; Pathan, 2009). However, this does

not suggest that shareholders prefer excessive risk; this is discussed in the following sections. The preceding discussion

leads to the following hypothesis:

H1a. The composition of the compensation committee is positively associated with the risk level of financial firms.

H1b. The composition of the risk committee is negatively associated with the risk level of financial firms.

2.2. Directors dual membership on the RC and CC

WhileBradbury (1990: 22)argues that audit committees reduce information asymmetry between insiders and outsiders

of the firm,Reeb and Upadhyay (2010)suggest that separating directors into specialised committees can create information

asymmetries among directors. Similar to the costs of organisational decentralisation, forming board sub-committees can

lead to suboptimal decisions by the board as committee members focus on their particular area of responsibility instead

of focusing on the overall goal of board decisions. Consequently, the costs of board sub-committees are co-ordination and

communication problems. It is posited in this study that a potential solution to this problem is to ensure directors mutual

involvement in committees that are likely to have some impact on each other. For example, one of the roles of the risk com-

mittee is to determine the appropriate level of risk the firm should take while the compensation committee may design

remuneration packages with the purpose of increasing managers risk-taking. Therefore, it seems apparent that these com-

mittees should co-ordinate and communicate when making decisions.

Board committees often work independently to achieve their own objectives. However, there are cases where differentcommittees are staffed by a common group of members ( Laux and Laux, 2009). In these circumstances, Laux and Laux

(2009)suggest an association between the members who serve on both the compensation and audit committee and exec-

utives pay structure. Specifically, the model developed byLaux and Laux (2009)suggests that separating the functions of the

audit and compensation committee members should lead to a higher proportion of pay-for-performance compensation and

subsequently increases the monitoring role of the audit committee in the financial reporting process. This is because when

compensation committee members also serve on the audit committee, they prefer to reduce CEO incentives to manipulate

earnings by lowering incentive pay which in turn leads to lower levels of monitoring.Hoitash and Hoitash (2009)empirically

test this hypothesis and find a higher degree of dual committee membership is associated with a lower proportion of CEO

incentive compensation.

Similarly, this study considers the co-ordination of monitoring committees (RC and CC) as important. Agency theory pre-

dicts that managers who are compensated based on firm performance are more likely to undertake all positive net present

value projects without being overly concerned about the associated risks. If the design of the compensation package has the

potential to reduce self-serving behaviour, then CC efficacy should also mean higher risk. However, certain compensationpolicies may encourage excessive managerial risk-taking rather than investing firm resources in a risk-neutral manner

(Miller et al., 2002).

Asset pricing theories suggest that no level of risk is excessive for diversified shareholders in non-financial firms because

the failure of one firm does not adversely affect their diversified portfolio. However,Gordon (2011, p. 5)suggests that share-

holders in the financial sector prefer less risk as the failure of a systemically important financial firm will reduce the value of

a diversified shareholders portfolio from the subsequent increase in the systematic risk-bearing premium. In addition, re-

search suggests that instead of looking at risk management from a silo-based perspective, firms that take a holistic view

of risk management will improve firm performance (Gordon et al., 2009).8 Consequently, communication and co-ordination

between the RC and the CC is important for firms in the financial sector and means that directors with multiple committee

membership are likely to act more conservatively to avoid excessive risk-taking and the threat of firm failure.

Therefore, when setting the incentive payment policy the compensation committee must consider whether their policy

fits within the firms risk appetite. Successful monitoring requires communication with members internally and across

8 The holistic view of risk management is referred to as enterprise risk management.



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committees (Raber, 2003). As directors have specific knowledge to serve the committee on which they sit, it is expected that

having the same directors on both committees would result in better monitoring in terms of setting appropriate compensa-

tion packages and managing excessive risk. The second hypothesis is:

H2. Directors dual membership on the compensation and the risk committees is negatively associated with risk.

2.3. Risk and firm performance

According to asset pricing models a rational investor should not take on any diversifiable risk (unsystematic risk or idi-

osyncratic risk), as only non-diversifiable (systematic or market) risk (beta) is rewarded. A sufficiently diversified portfolio

limits the risk exposure to systematic risk only and the level of systematic risk is not affected by the failure of any one firm.

Therefore, the return that compensates investors for the risk taken must be linked to its riskiness in a portfolio context. That

is, the beta of the financial sector is the defining factor in rewarding the systematic exposure taken by an investor ( Bodie

et al., 2009). Consequently, the failure of a systemically important financial firm will increase the likelihood that other finan-

cial firms will fail (Gordon and Muller, 2011) and lowers the expected return in the financial sector (Gordon, 2011).Gordon

and Muller (2011)suggest that shareholders in the financial sector internalise, at least partially, the consequences of firm

failure (systemic risk) and are more wary of excessive risk-taking. Therefore, there is a negative association between risk

and performance at excessive levels of risk because ever increasing levels of risk result in greater uncertainty and risk of de-

fault which in turn leads to lower returns.

Studies of the association between committee composition and financial performance of non-financial firmsare mixed, fail-

ing to find any significant relationship (Ellstrand et al., 1999), finding a negative association (Klein, 1998), or finding a positive

association (Young and Buchholtz, 2002). Reeb and Upadhyay (2010), in a studyof eleventypesof committees in non-financial

firms, find that the finance, corporate governance, public issue/diversity committees are positively associated with perfor-

mance (TobinsQ). Adams andMehran(2008) find that thenumberof committees is negatively associatedwith TobinsQ which

is consistent with the concept of the costs of co-ordination and communication problems with board sub-committees.

Gordon et al. (2009)suggest that a positive association between risk and performance is contingent on the match be-

tween risk management and firm-related characteristics. Following this train of thought, we do not expect a direct relation-

ship between CC or RC composition and firm performance9. Instead, we posit that in situations of high uncertainty, such as

high levels of risk, firms need committees that are competent in managing and monitoring risk. Firm risk refers to the under-

lying volatility of firms earnings and has been identified as a source of agency conflict (Bathala and Rao, 1995). Firm risk, as a

measure of the firms information environment and the risk of its operating environment, is also a potentially important deter-

minant of firm performance. In an effort to reduce these risks firms use monitoring (RC) and incentive alignment mechanisms

(CC) that aim to alter the risk and effort orientation of agents. Firms seek to address this problem by structuring their boards

(and committees) to ensure sufficient monitoring of managerial behaviour and to curb excessive risk-taking.

The efficacy of the RC and CC in monitoring and identifying excessive risk-taking depends on the composition and size of

the RC and CC which, in turn, leads to better performance. Compensation and risk committees comprised of recommended

governance characteristics lead to better designed compensation contracts and risk monitoring that can motivate managers

to make superior decisions, resulting in better firm performance. Committee members are also motivated to do their job well

as their value in the human capital market depends primarily on the performance of their companies ( Harrison and Harrell,

1993). Hence, committee detection of excessive risk-taking will ultimately lead to lower levels of risk and a positive asso-

ciation between risk and performance. Simply, we expect that a positive association between risk and performance depends

on the composition of the compensation and risk committee. This leads to the third hypothesis.

H3a. A positive association between risk and performance depends on the composition of the risk and compensation

committee.

Further, if dual membership mitigates the communication and co-ordination problems of board sub-committees then weexpect to see the goals of the CC and the RC aligned with shareholders risk preferences and a positive association between

risk and performance. This proposition is related toGordons (2011, p. 6)suggestion that even though shareholders may not

internalize all of the costs of systemic distress. . .their internalized losses are sufficient to justify appropriate measures to

control financial firm risk-taking. We investigate whether members of the RC and CC coordinate to manage risk and return.

In other words, does the CC consider whether the compensation package motivates risk-taking which is aligned with the

firms risk appetite and subsequently is associated with better firm performance? Consequently, committees provide mon-

itoring that is necessary to restrain excessive risk-taking but the committees must communicate and co-ordinate to reduce

information asymmetry and achieve shareholders objectives. This leads to the last hypothesis:

H3b. There is a positive association between risk and performance when there is director dual membership on the

compensation and the risk committees.

9

Along a similar vein, Sun et al. (2009) find that a positive association between future firm performance and stock option grants depends on increasingcompensation committee quality.

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3. Method

3.1. Sample selection

The financial sector in 2008 consists of 265 firms listed on the Australian Securities Exchange (ASX, 2010). The sector in-

cludes diversified financials, banks, insurance, real estate companies and real estate investment trusts. Financial sector com-

panies are examined in this study because they are operating in a riskier environment compared to other industries (Pathan,

2009) and are often excluded in corporate governance studies. The sample consists of an unbalanced panel data set of 317ASX listed firms in the financial sector for the years 2006 to 2008 (711 observations) based on the availability of the relevant

data. Archival data on firms corporate governance characteristics (including committee characteristics) is hand collected

from the company annual reports from Connect4. Financial variables are provided by Aspect FinAnalysis. Risk measures

are obtained from the Centre for Research in Finance (CRIF) risk measurement service of the Australian School of Business,

University of New South Wales.

Consistent with prior research we determine the characteristics of firms that establish an RC or CC (e.g., Subramaniam

et al., 2009; Yatim, 2010). The sample is then broken down into risk committee and compensation committee subsamples.

There are 236 observations (126 firms) with a risk committee, 337 (156 firms) with a compensation committee, and 185

observations (96 firms) with both committees for testing the hypotheses.

3.2. Research model

There are two dependent variables in this study: risk (BETA) and firm performance (LNEPS). Our principal measure of riskis beta. Beta is the slope coefficient from a simple linear regression of the company equity rate of return on that of the market

index, where both are measured as deviations from the risk free rate. Beta is a measure of market risk and is expressed as a

coefficient whose average value for the market as a whole is unity. A high beta stock (beta greater than unity) is one that is

relatively sensitive to market movements, and a low beta stock (beta less than unity) as relatively insensitive. This measure

has been adjusted for thin trading. As an alternative risk measure, we use total risk which is calculated as the standard devi-

ation of firm daily stock returns for each fiscal year (STD.DEV). It is measured as the standard deviation of the rate of return

on equity for the company and is expressed as a rate of return per month computed from the (continuously compounded)

equity rates of return for the companys equity.10

The relationship between risk and firm performance has been widely studied by researchers in business management,

economics, accounting and finance. Asset pricing models generally specify that shareholders are compensated for bearing

risk by receiving higher returns. Although there are various measures of firm performance used in prior research, this study

uses the firms earnings per share (EPS) because (1) income-based risk is used in the analysis and EPS also reflects the income

of the firm, (2) EPS is likely to be influenced by the firms managerial risk-taking behaviours which is the emphasis of thisstudy and (3) it is a performance measure that is common amongst all financial firms thus allowing comparability. Prior re-

search has also used this measure of financial performance in the financial sector (e.g. Doucouliagos et al., 2007;Luo, 2003).

We also used share market returns in robustness tests.

We formally investigate Hypotheses 13 using random effects generalised least square (GLS) regression estimated with

clustered-robust (also referred to as Huber-White) standard errors to control for any serial dependence in the data (Gow

et al., 2010;Petersen, 2009). The results of the Hausman test determine that a random effect GLS regression model is appro-

priate to test the panel data. Panel data is often cross-sectionally and serially correlated, thereby violating the common

assumption of independence in regression errors (Gow et al., 2010). Hence, clustered standard errors are unbiased as they

account for the residual dependence (Petersen, 2009). According toPetersens (2009)simulations, clustered robust standard

errors are correct in the presence of year effects (if year dummies are included), with no assumed parametric structure for

within-cluster errors, so that the firm effect can vary both spatially and temporally. We include dummy variables for each

period (to absorb the time effect) and then cluster by firm.

The definitions of the individual independent and control variables are reported inTable 1. The models are run separatelyfor each committee; otherwise the analysis would only include firms that have both committees. The risk and compensation

committee models follow

BETA b0b1COM FACt b2COMSIZEt b3COM CEOt b4LNEPSt1b5LNASSETSt b6LEVERAGEt

b7BSIZEt b8YEARt b9SEGMENTte 1

BETA b0b1DUALt b2RCCEOt b3LNEPSt1b4LNASSETSt b5LEVERAGEt b6BSIZEt b7YEARt

b8SEGMENTte 2

10 It is measured over the 4-year period ending at the companies annual balance date. All measurable monthly returns in the four-year interval are included.

Individual monthly returns measure total shareholder returns for the company, including the effects of various capitalisation changes such as bonus issues,renounceable and non-renounceable issues, share splits, consolidations, and dividend distributions.

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LNEPSt1 b0b1COM FACt b2COMSIZEt b3BETAt b4COM FACt BETAt b5COMSIZE BETAt b6COM CEOt

b7LNEPSt b8LNASSETSt b9LEVERAGEt b10BSIZEt b11YEARtb12SEGMENTte 3

LNEPSt1 b0b1

DUALt b2

BETAtb3

DUAL

BETAt b4

RCCEOtb5

LNEPStb6

LNASSETSt

b7LEVERAGEt b8BSIZEt b9YEARt b12SEGMENTte 4

3.2.1. Independent variables

In order to communicate effectively and avoid the problem of diffusion of responsibility, the committee should be rela-

tively small. While the ASX CGC recommends that the compensation committee should have a minimum of three members,

there is no such guideline for the risk committee. There are two schools of thought with regard to optimal size. As size in-

creases, so does the incremental cost of poorer communication, diffusion of responsibility and ineffective decision making

(Yermack, 1996). Conversely, a larger committee may bring a greater depth of knowledge and diverse skills essential for

monitoring risk and compensation practices. Consequently, the size of the committee is likely to be associated with its ability

to monitor risk. Consistent with prior research, committee size is the total number of committee members (Hoitash and

Hoitash, 2009; Petra and Dorata, 2008; Sun et al., 2009). We do not predict a direction for the association between committee

size and either risk or performance due to inconclusive evidence for either a positive or negative association.

Similar to previous governance research (e.g. Sun et al., 2009) we develop a factor score (COMFAC) for RC and CC compo-

sition using a principal components analysis of five of the six individual measures of committee characteristics. We exclude

committee size (COMSIZE) from the factor analysis due to theoretical and empirical confusion as to whether large or small

committees are better monitors. In addition, small values in the structure detection factor analysis indicate that committee

size does not fit well with the factor solution and should be dropped from the analysis. Using a factor score is attractive be-

cause it extracts a component that is common to five committee characteristics. The rationale for the committee character-

istics that demonstrate good governance practice is well established in the literature and we expect the factor score to be

positively associated with risk and performance. Justification for the components of the factor score follow.

Committee independence (CC/RCIND) is assessed according to compliance with the ASX CGC (2007: 16)definition of an

independent director. The information is disclosed either in the corporate governance statement or the directors report in

the companys annual report. The measure is based on the proportion of independent directors on the committee (Anderson

and Bizjak, 2003; Vafeas, 2003a). Consistent with prior research (Klein, 2002; Xie et al., 2003) we measure committee activityusing meeting frequency (CC/RCMEET) as a proxy.

Table 1

Definition of variables.

Variable Measurement

Dependent variables

BETA Market risk is the slope coefficient the companys equity rate of return adjusted for thin trading

LNEPSt+1 The natural log of reported net profit after tax before abnormal items and less outside equity interests and preference

dividends divided by diluted weighted number of shares outstanding during the year plus 1

Independent variables

Committee characteristics used to derive the COMFAC score for CC and RC efficacy

COMFAC Principal components factor analysis of the following five components

CC/RC IND Percentage of independent directors to total directors on the committee

CC/RCPRO Percentage of directors with professional qualification to total directors on the committee

CC/RCSENIORIND Percentage of directors who have P10 years industry services to total directors on the committee

CC/RCSENIORBoD 1 if a committee hasP10 year board service and 0 otherwise

CC/RCMEET Number of meetings the committee held per year

We use COM to denote either risk or compensation committee in the equation and report CC or RC variables separately

COMSIZE Number of directors on the compensation or risk committee.

DUAL 1 if there is a member who serves on both the compensation and the risk committee and 0 otherwise

Interaction terms

COMFACBETA Interaction of COMFAC and BETA

COMSIZEBETA Interaction of COMSIZE and BETA

DUALBETA Interaction of DUAL and BETA

Control variables

COMCEO Dummy variable equals 1 if the CEO is also a member of the compensation or risk committee

LNEPSt The natural log of reported current earnings per share before abnormal items at year t

LNASSETS The natural log of firms total assets in million dollars

LEVERAGE The ratio of total liabilities to total assets

BSIZE The total number of directors on board

YEAR Dummy variable for year 2006, 2007, 2008

SEGMENT Dummy variable equals 1 if firm is a bank, diversified financial, insurance, REIT, or real estate; 0 otherwise

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Regulators have called for more financial experts on boards following the recent global financial crisis and the increased

incidence of accounting scandals (Gner et al., 2008). The basic assumption is that directors with a better understanding of

financial principles and standards will be better equipped to fulfil their monitoring role of risk avoiding behaviour. The pro-

fessional expertise of individual committee members (CC/RCPRO) is measured by identifying professional qualifications in

accounting or finance (e.g., Certified Practising Accountant (CPA), Chartered Accountant (CA) or Chartered Financial Analyst

(CFA)). This measure is consistent with that ofPetra and Dorata (2008)andSapp (2008)who examine the relationship be-

tween committee expertise and executive compensation.

Long-serving directors are likely to be adept at monitoring risk because of their greater experience (e.g., Vafeas, 2003b)

and because they have greater firm-specific reputational capital at stake ( Fama and Jensen, 1983). Conversely,Bebchuk and

Fried (2006)argue that long-serving directors are likely to become entrenched and therefore pursue their own objectives.

Directors who have longer tenure on the board (10 years or more) are likely to have greater knowledge and experience in

compensation and risk management practices (CC/RCSENIORBoD). This measure is consistent withSun et al. (2009). We also

measure committee expertise based on members industry experience. Directors with longer tenure in the financial sector

would have superior experience in determining an appropriate risk appetite for the company. Therefore, we use the propor-

tion of directors who have 10 or more years of industry experience to measure committee expertise (CC/RCSENIORIND).

Hoitash and Hoitash (2009)measure the interaction between the compensation and audit committee by identifying the

number of board members who serve on both committees. This study measures the co-ordination of the compensation and

risk committee by creating a dummy variable that identifies whether there are directors who have responsibilities on both

committees (DUAL).

3.2.2. Control variables

We use the current years, reported earnings per share, as it is likely to have an impact on the current level of either risk or

performance (LNEPSt). Firm size is often included as a control variable in previous corporate governance studies (Devers

et al., 2008; Miller et al., 2002; Pathan, 2009; Sun et al., 2009), as an increase in firm size is likely to lead to greater perfor-

mance, while firm size is negatively associated with firm risk (Pathan, 2009). We perform a natural log transformation of the

variables of EPS and firm size (LNASSETS) to normalise the residuals. Consistent with previous research (e.g., Pathan, 2009)

leverage (LEVERAGE) is also included as a control variable as it is an important determinant of a companys risk of bankruptcy

and consequently it is also associated with profitability.

Board size (BSIZE) is included in the model as a control variable because there is greater probability that larger boards will

establish committees (Subramaniam et al., 2009; Yatim, 2010) and research in the financial sector finds a negative associ-

ation between board size and firm risk (Pathan, 2009). CEO membership refers to when the CEO is a member of the CC or

RC (COMCEO). Where the CEO is involved in the CC, they can determine their own compensation and it is possible they will

design their compensation to benefit themselves, regardless of the impact on risk or performance. Similarly, the involvement

of the CEO in the RC means that the CEO is actively involved in monitoring the level of risk. With greater inside information,

the CEO may bring to the committee a level of expertise that reduces the risk level of the firm. On the other hand, the CEO

may be motivated to act opportunistically, undertaking such activities as empire building and excessive or unrelated diver-

sification (Baysinger and Hoskisson, 1990), leading to increased levels of risk. We also control for year (YEAR) and sector seg-

ments (SEGMENT). Different segments may be subject to different regulations and therefore may not be an homogenous

group for testing the hypotheses.

4. Results

Table 2reports the descriptive statistics for the variables related to risk, firm characteristics, firm performance and com-

pensation and risk committees. Of the 711 observations, 47% disclose the existence of a CC in their annual reports. Only 33%

of the sample firms have a stand-alone RC and only 26% have both committees. Even though the existence of compensation

and risk committees is expected to result in improved effectiveness in the overall system of governance (ASX CGC, 2007),

financial companies commonly choose not to establish such committees.

The beta coefficient has a mean of 1.27, indicating a high level of market risk facing financial firms in the period 2006

2008. The mean score for the standard deviation of monthly returns (STD.DEV) for the full sample of 711 observations is

10.60, suggesting a great variability of returns for financial firms. The characteristics of the compensation committee include

an average size of 3.20.11 The percentage in independent directors on the CC is 75%, 12Twenty two percent of the sample has at

least one director with 10 or more years of board experience and 73% of the CC has members with at least 10 years industry

service. On average, 28% of the CC members has either an accounting and/or finance professional qualifications. The average

number of CC meetings during 2006-2008 is 2.9113 and 6% of CEOs sat on the committee of the CC sample.

11 There are two CC that have only one member. There are 71 cases (9.96%) where CC has fewer than the ASXCGC recommendation of a minimum of three

members.12 Unreported results show that 20.2% have a CC consisting solely of independent directors while only 1.26% have no independent directors on the CC.13

One, two and three CC had no meeting in 2006, 2007 and 2008 respectively. These committees all have more than two members.



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Table 2

Descriptive statistics.

Variable-continuous ALL YEARS (N= 711) 2006 (N= 219) 2007 (N= 244)

Mean Median Std. dev. Mean Median Std. dev. Mean Median Std. dev. BETA 1.274 0.95 1.840 1.255 0.820 1.915 1.102 0.89 2.049

STD.DEV 10.60 8 8.123 10.325 7.7 8.355 9.709 6.9 7.801

COMSIZE(CC) 3.20 3 0.937 3.19 3 0.981 3.280 3 0.923

CCIND 75.13% 75% 26% 77.27% 75 % 24.02% 75.03% 75% 24.7%

CCSENIORIND 73.22% 75% 28.44% 68.44% 67% 25.76% 68.86% 67% 28.70%

CCSENIORBoD 21.93% 0% 28.74% 24.10% 0% 29.40% 19.38% 0% 26.15%

CCPRO 0.284 0.333 0.288 0.264 0.25 0.274 0.250 0.25 0.259

CCMEET 2.911 2 1.997 3.19 3 1.870 2.85 2 2.074

COMSIZE(RC) 3.61 3 1.429 3.97 4 1.657 3.6 3 1.448

RCIND 80% 93% 24.10% 79.61% 75% 22.44% 78.65% 81.50% 25.55%

RCSENIORIND 75.10% 81.50% 28.77% 72.8% 74% 26.18% 72.18% 75% 30.47%

RCSENIORBoD 13.10% 0% 23.81% 15.4% 0% 23.75% 12.48% 0% 22.02%

RCPRO 0.322 0.330 0.277 0.304 0.330 0.243 0.294 0.330 0.264

RCMEET 4.75 4 2.496 5.38 5 2.859 4.44 4 2.389

EPSt 25.480 8.6 71.165 30.442 13.6 58.99 35.763 14.6 66.484

BSIZE 5.54 5 2.021 5.45 5 1.945 5.62 5 2.027

ASSETS($million) 11,055 184 59,583 10,191 159 51,958 10,603 174 578,168

LEVERAGE 0.547 0.410 0.816 0.465 0.370 0.405 0.721 0.46 1.266

Variable-dichotomous Coding Observations % of sample Coding Observations % of sample Coding Observations % of samp

CCEXT 1 337 47 1 98 44.3 1 118 47.6

COMCEO(CC) 1 42 6 1 12 5.4 1 12 4.8

RCEXT 1 236 33 1 60 27.1 1 82 33.1

COMCEO(RC) 1 25 3.5 1 6 2.7 1 8 3.2

DUAL 1 185 26 1 49 22.2 1 58 23.4

BETA: market risk; STD.DEV: total risk; COMSIZE: number of directors on the committee; CC/RC IND: percentage of independent directors to total directors on

directors withP10 years industry services divided by total directors on the committee; CC/RCSENIORBoD: 1 if a committee has memberP10 year board service an

with professional qualification divided by total directors on the committee;CC/RCMEET: number of meetings the committee held per year; EPSt: reported current

t;BSIZE: the total number of directors on board; ASSETS: firms total assets in million dollars;LEVERAGE: the ratio of total liabilities to total assets; CCEXT/RCEXT:

otherwise;COMCEO: dummy variable equals 1 if the CEO is also a member of the CC/RC;DUAL: 1 if a member serves on the CCand RC; and 0 otherwise.


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In relation to the risk committee characteristics, the average membership is 3.61.14 Members of the RC are primarily inde-

pendent directors (80%)15. Over 75% of RC members have more than 10 years of industry service and 13% have members that are

long-serving (P10 years board service). On average, 32% of RC members are professionally qualified in accounting and/or fi-

nance. The average number of RC meetings is 4.75 per year.16 Only 3.50% of the RC observations report that the CEO is on

the RC. Of the 185 observations that have both a RC and a CC, 26% have a member who serves on both committees.

The descriptive statistics of the untransformed firm characteristics and firm performance variables ( EPSt, BSIZE, ASSETS

and LEVERAGE) are also presented in Table 2. Board size ranges between 2 and 13 members with a mean of 5.54.17 The sample

of financial firms has, on average, total assets of $11,055 million and leverage of 0.55.EPSthas a mean of 25.48. Overall, there are

no apparent or significant differences in characteristics of financial firms over the period 2006-2008. Interestingly, there is a

gradual increase in committee formation over the 3 years.

Table 3a and b reports the details of the sample by industry over the three years. The sample comprises 711 firms: 24

insurance companies (3.4%), 43 banks (6.1%), 120 real estate firms (16.9%), 145 real estate investment trusts (20.4%) and

379 diversified financial companies (53.2%).Consistent with prior research (e.g.,Subramaniam et al., 2009) our first test is to determine the characteristics of financial

firms with these committees. The results reported inTable 3b from the probit regressions show a positive association be-

tween the existence of the committees (RC and CC) and the size of the firm, the size of the board and the level of risk ( BETA).

This result suggests that firms with more inherent risk set up these committees to monitor and manage risk more closely.

Leverage is not significantly associated with the existence of the committees. Performance (LNEPSt) is positively and signif-

icantly associated with the existence of a CC. The sector of the finance industry is not significantly associated with forming a

CC or RC.

Table 3

(a) Details of the sample. (b) Probit regression-unbalanced data.

(a)

All years 2006 2007 2008

Observations % Observations % Observations % Observations %

Insurance 24 3.4 10 4.6 4 1.6 11 4.4

Bank 43 6.1 16 7.3 11 4.5 15 6.0

Real estate 120 16.9 37 16.9 34 13.9 49 19.8REIT 145 20.4 45 20.5 55 22.5 45 18.1

Diversified financial 379 53.2 111 50.7 140 57.4 128 51.6

Total 711 100% 219 100% 244 100% 248 100%

(b)

RCEXT z CCEXT z DUALEXT z

Constant 7.545 (1.13) 25.022 (3.64)*** 12.325 (0.03)

BETA 0.133 (3.80)*** 0.104 (3.28)*** 0.041 (0.42)

LNEPSt 0.505 (0.52) 3.224 (3.24)*** 3.273 (2.04)***

LNASSETS 0.124 (4.36)*** 0.113 (4.08)*** 0.171 (1.80)*

LEVERAGE 0.072 (1.13) 0.113 (1.49) 2.118 (2.84)**

BSIZE 0.163 (4.51)*** 0.169 (4.80)*** 0.208 (2.38)**

YEAR Yes Yes Yes

BANKS 0.140 (0.17) 0.539 (0.56) 5.703 (0.01)

DIVERSIFIED 0.165 (0.20)

0.565 (

0.60)

4.817 (

0.01)INSURANCE 1.040 (1.08) 0.681 (0.69) Omitted

REIT 0.239 (0.29) 0.594 (0.63) 4.715 (0.01)

REALESTATE 0.341 (0.41) 0.487 (0.51) 5.291 (0.01)

Pseudo R2 0.179 0.163 0.260

Chi2 161.19 160.79*** 34.09***

N 711 711 185

RCEXT,CCEXT= a dummy variable 1 if a risk or compensation committee exists; 0 otherwise;DUALEXT= a dummy variable 1 if both a risk and compensation

committee exists; 0 otherwise;BETA: market risk;LNEPSt: reported current earnings per share before abnormal items at year t;LNASSETS: the natural log of

firms total assets in million dollars; LEVERAGE: the ratio of total liabilities to total assets; BSIZE: the total number of directors on board; YEAR: dummy

variable for year; BANK, DIVERSIFIED,RESIT, REALESTATE: dummy variable for segment.* p< 0.10.** p< 0.05.*** p< 0.01.

14 There are three RC that have only one member.15 Of the 236 observations, 16.55% have an entirely independent RC (i.e., all members are independent directors), while less than 1% do not have any

independent directors on the RC (unreported).16 One RC had no meeting in 2006 and another one had no meeting in 2008. These two firms do not belong to the group of six firms that have only one

member on the RC.17 Only one board has fewer than the ASXCGC recommendation of at least three directors on the board.

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4.1. Common factor analysis for committee efficacy

The results of the factor analysis are presented inTable 4. Panel A shows the estimated communalities for each of the five

committee efficacy measures. Panel B presents the eigenvalues of the reduced correlation matrix of the five committee effi-

cacy measures. Panel C presents the correlations between the common factor and the five measures of committee efficacy.The extracted components explain nearly 50% of the variability in the original five variables.

4.2. GLS regression results

The results of testing H1 are reported inTable 5. The results show a positive and significant association between the CC

characteristics and risk (B= 0.229;z= 2.61), thus supporting H1a. We also find a marginally significant association between

RC characteristics and BETA (B= 0.235;z= 1.68) thus rejecting H1b. However, the positive association does not demonstrate

excessive or value increasing risk levels. The models show risk (BETA) is negatively and significantly associated with firm

performance (LNEPSt) which suggests that excessive risk-taking is associated with lower firm performance. In other words,

excessive risk-taking increases the probability of failure. Hypothesis 2 posits that directors dual membership on the com-

pensation and the risk committee is negatively associated with risk as dual membership is likely to ensure less excessive

risk-taking due to the communication between the RC and the CC. The result is negative but not significant, thus failing

to support H2.

The results for testing H3a and H3b are reported inTable 6. We fail to find that a positive association between risk and

performance depends on the characteristics of the RC or the CC. However, we find a negative association between risk

and performance is associated with increasing the size of the CC (B= 0.003;z= 2.84). The interaction between dual mem-

bership and risk is positively and significantly associated with performance (B= 0.011;z= 2.15), supporting H3b. While test-

ing the hypotheses, we discovered that many 2008 firms were delisted in 2009. Consequently, we ran the tests using the

2006 and 2007 observations (not reported here). The result for dual membership is statistically and economically more

significant.

In this paper we do not posit a basic relationship between committee composition and firm performance. Such an asso-

ciation is open to the criticisms of endogeneity of the variables because committee composition can affect firm performance

and firm performance can, in turn, affect committee existence. Instead, we posit that a positive association between risk and

performance depends on committee composition. That is, committee composition moderates the negative association be-

tween excessive risk and performance. We control for potential endogeneity by using instrumental variables that are relatedto committee composition but are not related to performance in year t+ 1 and run a 2SLS regression. The instrumental vari-

Table 4

Common factor analysis of the measures of committee efficacy (N= 337 firms with CC; N= 236 firms with RC).

CC RC

Panel A: Estimated communalities of five measures of committee efficacy

Committee independence 0.448 0.704

Proportion of committee with 10 or more years experience in the financial industry 0.660 0.716

Proportion of committee directors with 10 or more years experience on the board 0.236 0.674

Proportion of committee directors with an accounting and/or finance qualification 0.560 0.649

Committee meeting frequency 0.575 0.780

Component Eigenvalues

Total CC Cumulative % CC Total RC Cumulative % RC

Panel B: Eigenvalues of the reduced correlation matrix of committee efficacy measures

Committee independence 1.325 26.509 1.381 27.616

Proportion of committee with 10 or more years experience in the financial industry 1.153 49.577 1.122 50.052

Proportion of committee with 10 or more years experience on the board 0.994 69.458 1.020 70.450

Prop orti on of commit tee with an account ing and/or finance quali fica tion 0.833 86.119 0.856 87.578

Committee meeting frequency 0.694 100.000 0.621 100.000

CC RC

Panel C: Correlations between the common factor and five committee efficacy measures

Factor score 1 1Committee independence 0.669*** 0.284***

Proportion of committee directors with 10 or more years experience in the financial industry 0.003 0.116*

Proportion of committee directors with 10 or more years experience on the board 0.466*** 0.338***

Proportion of committee directors with an accounting and/or finance qualification 0.087 0.257***

Committee meeting frequency 0.756*** 0.877***

p< 0.05.* p< 0.10.*** p< 0.01.

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ables which are regressed against the existence and composition of the committees in the first stage are: LIABILITIESt(total

liabilities), CFOt1 (cash flows from operations in the preceding year), BSIZEt, and STD.DEVt1 (total risk in the preceding

year). We use these variables as research suggests that these factors are related to firms establishing committees (Bradbury,

1990; Carson, 2002; Piot, 2004;Ruigrok et al., 2006; Subramaniam et al., 2009; Yatim, 2010). Furthermore, using the one per-

iod lag variables (LIABILITIEStandBSIZEt) and the two period lag variables (CFOt1 andSTD.DEVt1) means the instrumental

variables are unlikely to be related to the lead variable of performance (LNEPSt+1) and further reduces the extent of endo-

geneity (Doucouliagos et al., 2007). The models are run separately for each committee; otherwise the analysis only includes

firms with both committees and reduces the sample to 146 observations.

The results of the 2SLS regressions are reported inTable 7. First, we test whether the existence of a RC, CC, or dual mem-

bership are associated with firm performance while controlling for endogeneity. The results show that the existence of the

RC and CC are positively and significantly associated with firm performance (B= 0.057; z= 4.10 and B= 0.076; z= 5.13

respectively). However the positive association between the existence of dual membership and firm performance is not sig-

nificant (B= 0.042;z= 1.57).Next we test the hypotheses using the 2SLS method to control for potential endogeneity. The results reported in Table 7

show a significant and positive association between committee characteristics (COMFAC(RC) and COMFAC(CC)) and

performance (B= 0.052; z= 2.41 and B= 0.042; z= 4.31 respectively). This result suggests that firm performance increases

when the risk and compensation committees consist of members who are independent of management, have industry

and board experience, are professionally qualified and meet frequently.

Turning our attention to the interaction terms, contrary to our prediction we find that the interaction of the COMFAC(RC)

and the COMFAC(CC) with BETA is negatively associated with performance (B= 0.016; z= 2.41; B= 0.017; z= 3.85

respectively). The size of the committees is not associated with either performance or moderating the association between

risk and performance. This result conflicts withYeh et al., 201118 who find that committee independence curbs excessive risk-

taking behaviour and improves firm performance particularly during a crisis period (20072008).

Table 5

Random effects GLS regression with cluster robust errors dependent variable: market risk (BETA).

Variables Committees

Predicted Compensation Risk Dual

Sign B z B z B z

Constant ? 42.50 (3.31)*** 41.34 (3.08)*** 39.05 (2.81)***

COMFAC(CC) + 0.229 (2.61)***

COMFAC(RC) 0.235 (1.68)*

COMSIZE(CC) ? 0.011 (0.12)

COMSIZE(RC) ? 0.146 (1.28)

DUAL 0.423 (0.79)

Control variables

COMCEO(CC) ? 0.090 (0.34)

COMCEO(RC) ? 0.184 (0.43) 0.299 (0.61)

LNEPSt + 6.114 (3.18)***

5.800 (2.83)*** 5.664 (2.62)***

LNASSETS + 0.085 (1.16) 0.139 (1.68)* 0.130 (1.27)

LEVERAGE + 0.185 (3.19)** 0.121 (1.33) 0.077 (0.87)

BSIZE + 0.088 (1.34) 0.111 (1.40) 0.163 (1.64)

YEAR ? Yes Yes Yes

BANK ? 0.326 (0.89) 0.705 (0.84) 1.167 (2.86)***

DIVERSIFIED ? 0.267 (0.81) 0.991 (1.26) 0.806 (3.53)***

INSURANCE ? Omitted Omitted Omitted

REIT ? 0.327 (1.03) 1.073 (1.36) 0.827 (2.73)**

REALESTATE ? 0.305 (0.87) 0.858 (1.05) 0.949 (2.84)***

R2 0.150 0.199 0.177

Wald chi 42.49*** 61.66*** 146.34***

N 336 235 185

Firms 157 126 96

BETA: market risk;COMFAC: factor score for committee characteristics; COMSIZE: number of directors on the committee;DUAL: 1 if there is a member who

serves on theCCand RCand 0 otherwise;COMCEO: dummy variable equals 1 if the CEO is also a member of the CC(RC);LNEPSt: reported current earnings

per share before abnormal items at yeart;LNASSETS: the natural log of firms total assets in million dollars;LEVERAGE: the ratio of total liabilities to total

assets;BSIZE: the total number of directors on board;YEAR: dummy variable for year;BANK,DIVERSIFIED,RESIT, REALESTATE: dummy variable for segment.

z-Statistics are in parentheses.* p< 0.10.** p< 0.05.*** p< 0.01.

18

Yeh et al. (2011) investigated the association between committee (audit, compensation, risk and nomination) independence and performance of the 20largest financial institutions from Australia, Canada, France, Germany, Italy, Japan, United Kingdom, and United States in the years 20052008.

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The results inTable 7show a positive association between risk and performance for firms with directors who have dual

membership on the risk and compensation committee. We find that the interaction of theDUALwithBETAis positively asso-

ciated with performance (B= 0.055;z= 3.39). This result supplements the research byLaux and Laux (2009)and recent re-

search byChandar et al. (2012)who find that firms with overlapping committee members on the audit and compensation

committee are associated with lower earnings management. BETAis consistently negatively and mainly significantly asso-

ciated with firm performance suggesting that increasing levels of risk increase the probability of failure, particularly in the

period leading up to the global financial crisis of 2008.The conjecture from this result is that financial firms with high systematic risk and consequently greater information

asymmetry need to co-ordinate the information and decisions made by the two committees. The threat of future losses

due to high risk and uncertainty justifies taking additional measures that control excessive risk-taking. When there are

directors with responsibilities in both committees they are able to oversee the association between the risk levels of the firm

and the risk-taking incentives of the compensation package. This result also implies that even though separation of commit-

tees may help individual committees to focus on their specific tasks, co-operation between the compensation and the risk

committee is advantageous for financial firms (in terms of improving firm performance). Thus, the collaboration between

these committees lowers information asymmetry and improves monitoring of compensation and risk levels which, in turn,

improves firm performance.

We also ran the 2SLS regression with clusters on firm and the results remain substantially unchanged. Finally, we test for

endogeneity in the regression estimated with instrumental variables and report the results of two tests in Table 8. The

Table 6

Random effects GLS regression with cluster robust errors dependent variable: performance (LNEPSt+1).

Variable Committees

Predicted Main effects Compensation Risk Dual

Sign B z B z B z B z

Constant ? 6.81 (37.89)*** 6.783 (36.74)*** 6.508 (22.95) 6.56 (25.93)***

COMFAC(CC) + 0.003 (1.07)

COMFAC(RC) 0.000 (0.11)COMSIZE(CC) ? 0.004 (1.49)

COMSIZE(RC) ? 0.002 (0.47)

DUAL 0.004 (0.38)

BETA 0.001 (1.81)* 0.009 (2.36)** 0.009 (1.07) 0.013 (2.87)***

COMFACBETA(CC) + 0.003 (1.46)

COMSIZEBETA(CC) ? 0.003 (2.84)***

COMFACBETA(RC) + 0.002 (1.63)

COMSIZEBETA(RC) 0.002 (0.67)

DUALBETA + 0.011 (2.15)**

Control variables

COMCEO(CC) ? 0.003 (0.97)

COMCEO(RC) ? 0.006 (0.94) 0.008 (0.76)

LNEPSt + 0.190 (7.14)*** 0.189 (6.85)*** 0.234 (5.64)*** 0.224 (5.89)***

LNASSETS + 0.000 (0.08) 0.001 (0.75) 0.000 (0.04) 0.001 (0.65)

LEVERAGE 0.001 (0.44) 0.000 (00.19) 0.005 (0.67) 0.005 (0.66)

BSIZE ? 0.000 (0.33) 0.000 (0.53) 0.000 (0.10) 0.000 (0.31)

BANK ? 0.004 (1.76)* 0.004 (0.58) 0.005 (0.58) Omitted

DIVERSIFIED ? 0.008 (6.04)*** 0.003 (0.45) 0.001 (0.28) 0.001 (0.12)

INSURANCE ? 0.008 (5.44)*** Omitted Omitted Omitted

REIT ? 0.007 (4.93)*** 0.003 (0.45) 0.000 (0.02) 0.001 (0.15)

REALESTATE ? 0.010 (4.78)*** 0.002 (0.34) Omitted 0.002 (0.24)

R2 0.405 0.506 0.534 0.60

Wald chi 554.98*** 196.92*** 111.12*** 273.00***

N 612 289 190 146

Firms 267 130 103 76

LNEPSt+1: reported net profit after tax before abnormal items during the year plus 1;COMFAC: factor score for committee characteristics;COMSIZE: number

of directors on the committee; DUAL: 1 if there is a member who serves on the CCand RC; and 0 otherwise;BETA: market risk;COMFACBETA: factor score

for committee characteristicsBETA; COMSIZEBETA: committee sizeBETA; DUALBETA: dual committee membershipBETA; COMCEO: dummy variable

equals 1 if theCEOis also a member of theCC(RC);LNEPSt: reported current earnings per share before abnormal items at year t;LNASSETS: the natural log of

firms total assets in million dollars; LEVERAGE: the ratio of total liabilities to total assets;BSIZE: the total number of directors on board;BANK,DIVERSIFIED,RESIT, REALESTATE: dummy variable for segment.


18

Yeh et al. (2011) investigated the association between committee (audit, compensation, risk and nomination) independence and performance of the 20largest financial institutions from Australia, Canada, France, Germany, Italy, Japan, United Kingdom, and United States in the years 20052008.

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DurbinWuHausman (DWH) tests and the WuHausman (WH) statistic test the null hypothesis on the regressors ( COM-

FAC(CC),COMFAC(RC) andDUAL). The tests estimate the model parameters within the ordinary least square (OLS) and two-

stage least square (2SLS) frameworks, and calculates the degree of variation between the OLS and 2SLS coefficients. The null

hypothesis is that there is no endogeneity in the equation, that is, there is no difference in the OLS and 2SLS estimates. The

significant WH and DWH tests (p= 0.009 and p = 0.005 respectively) indicate that the two sets of estimates are different.

Consequently, the null hypothesis is rejected, that is, endogeneity is present in the OLS estimates, and the instruments havecorrected for it. We can infer this as the 2SLS estimates are significantly different from the OLS estimates.

Table 8

Tests of endogeneity of: COMFAC(CC/RC), DUAL.

H0 Regressors are exogenous

WuHausmanFtest: 4.040 F(3,126) p= 0.009

DurbinWuHausman chi-sq test: 12.813 Chi-sq (3) p= 0.005

Table 7

Instrumental variables (2SLS) regression: dependent variable: performance (LNEPSt+1).

Variables Committees

Compensation Risk Dual Compensation Risk Dual

Constant 8.145 8.129 8.000 8.138 8.114 8.116

(440)*** (472)*** (216)*** (283)*** (208)*** (216)***

CCEXT 0. 076

(5.13)***

RCEXT 0. 057

(4.10)***

DUAL 0.042 0.060

(1.57) (2.43)**

COMFAC(CC) 0.042

(4.31)***

COMSIZE(CC) 0.003

(0.77)

COMFACTOR(RC) 0.052

(2.41)**

COMSIZE(RC) 0.001

(0.15)

COMFACBETA(CC) 0.016

(2.41)**

COMSIZEBETA (CC) 0.001

(0.47)

COMFACBETA(RC) 0.017

(3.85)***

COMSIZEBETA (RC) 0.001

(0.60)

DUALBETA 0.055

(3.39)***

BETA 0.005 0.003 0.008 0.010 0.003 0.061

(4.03)*** (3.59)*** (4.15)*** (1.26) (0.35) (3.84)***

LNASSETS 0.003 0.001 0.005 0.000 0.001 0.004

(2.57)*** (1.37) (4.49)*** (0.02) (0.27) (3.01)***

LEVERAGE 0.003 0.002 0.005 0.001 0.003 0.002

(1.68)* (1.25) (1.42) (0.57) (0.64) (0.49)

GROWTH 0.000 0.001 0.001 0.001 0.001 0.001

(0.16) (0.91) (0.65) (0.52) (0.50) (0.41)

N 612 612 146 289 190 146Wald chi2 44.04** 40.84*** 42.64*** 53.91*** 27.04*** 37.80***

LNEPSt+1: reported net profit after tax before abnormal items during the year plus 1; RC/CCEXT: dummy variable equals 1 if the firm has a RC/CC; and 0

otherwise; DUAL: 1 if there is a member who serves on the CCand RC; and 0 otherwise; COMFAC: factor score for committee characteristics; COMSIZE:

number of directors on the committee; BETA: market risk; COMFACBETA: factor score for committee characteristics BETA; COMSIZEBETA: committee

sizeBETA; DUALBETA: dual committee membershipBETA; COMCEO: dummy variable equals 1 if the CEO is also a member of the CC(RC); LNASSETS: the

natural log of firms total assets in million dollars; LEVERAGE: the ratio of total liabilities to total assets; GROWTH: price to book value calculated as the

closing share price on the last day of the companys financial year divided by shareholders equity per share.




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4.3. Robustness testing

To ensure the validity of the results we run models 14 using the standard deviation of returns (STD.DEV) measured as

the standard deviation of the rate of return on equity for the company and is expressed as a rate of return per month com-

puted from the (continuously compounded) equity rates of return for the companys equity. The results remain consistent

with the Beta results. As mentioned earlier, hypothesis testing is also carried out using the individual characteristics of the

RC and CC. The results are consistent with the factor score results; the individual CC characteristics are significant while the

individual RC characteristics are not significant.

5. Conclusion

This study provides some illumination towards the importance of corporate governance mechanisms as well as the man-

agement of risk in Australian financial companies. In the context of agency theory, there are incentives for companies to

establish corporate governance controls, such as board committees, due to the inability of shareholders to directly monitor

managerial actions (Jensen and Meckling, 1976). This empirical study of Australian firms in the financial sector over the per-

iod 20062008 provides some evidence of the importance of committees in managing risk to improve firm performance. The

findings from this study demonstrate that it is important to have compensation and risk committees with members who are

independent of management, have industry and board experience, are professionally qualified and meet frequently. More

importantly, this study finds that when committee members serve on both the risk committee and the compensation com-

mittee the firms level of risk exposure is monitored more closely so that there is a positive association with risk and per-

formance. This result suggests that coordination and communication problems are alleviated when committee membersresponsibilities transcend tasks. Future research could investigate this finding further by interviewing risk and compensation

committee members.

This study is the first to examine the relationship between corporate governance controls (i.e., compensation and risk

committee) and risk management in Australian financial companies. Practical implications of the study include the demon-

stration of the benefits of co-ordinating monitoring committee functions. Dual committee membership has a positive risk

and performance outcome which may mitigate the tendency of some compensation committees to design compensation

packages which inadvertently lead to excessive risk-taking and poor performance.

Acknowledgements

We wish to acknowledge the helpful comments and suggestions of the anonymous reviewer, the editor, Ferdinand A. Gul,

Lynn Gallagher, Tom Smith and the participants at the 2011 AFAANZ conference Darwin and the 2012 Financial Markets and

Corporate Governance conference, Melbourne.

Appendix A. Appendix

Prudential Standard APS 510 on Governance

The key requirements of this Prudential Standard include:

Specific requirements with respect to Board size and composition.

The chairperson of the Board must be an independent director.

A Board Audit Committee must be established.

Regulated institutions must have a dedicated internal audit function.

Certain provisions dealing with independence requirements for auditors consistent with those in the Corporations

Act 2001.

The Board must have a Remuneration Policy that aligns remuneration and risk management. A Board Remuneration Committee must be established.

The Board must have a policy on Board renewal and procedures for assessing Board performance.

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