Role of risk and compensation committees in managing financial firm risk

Journal of Contemporary Accounting & Economics 9 (2013) 8399
Contents lists available at SciVerse ScienceDirect
Journal of Contemporary
Accounting & Economics
journal homepage: www.elsevier.com/locate/jcae
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 monitoring the risk behaviour of Australian nancial rms in the period leading up to the global
nancial crisis (20062008). This empirical study of 711 observations of nancial sector
rms demonstrates how the coordination of risk management and compensation committees 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 rm 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 rm performance for rms with high risk.
2013 Elsevier Ltd. All rights reserved.
1. Introduction
Recent corporate scandals of nancial institutions worldwide have raised considerable concern among investors and regulators. Regardless of whether the global nancial crisis resulted from excessive risk-taking (Kashyap et al., 2008), or is
attributable to the increasing levels of risk faced by rms (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 nancial sector. The nancial sector in
Australia is the largest industry sector based on capitalisation. As of June 2011 the 288 companies in the nancial sector of
Australia have a market capitalisation of AU$455.7 billion. The nancial sector consists of trading and investment banks, asset managers, insurance companies, real estate investment trusts (REIT) and other providers of nancial services. In Australia, employers in all sectors are required to contribute to a compulsory employee superannuation scheme.1 This means
Australia has the 4th largest pension fund pool in the world, creating enormous opportunities for banks, asset management,
nancial planning and insurance companies.2 Consequently, the governance practices of this sector are important to the economic welfare of Australia.
Agency theory suggests that there are divergent risk preferences of risk-neutral (diversied) shareholders and risk-averse
managers which necessitates monitoring by the board (Jensen and Meckling, 1976; Subramaniam et al., 2009). Consequently, without monitoring, risk-averse managers may reject protable (but more risky) projects which are attractive to
shareholders who prefer the increased return from the higher level of risk. Excessive managerial risk-taking is not considered
Corresponding author. Address: Queensland University of Technology, School of Accountancy, P.O. Box 2434, Brisbane, Australia. Tel.: +61 7 3138 2739;
fax: +61 7 3138 1812.
E-mail address: m.hutchinson@qut.edu.au (M. Hutchinson).
1
Employers are required by law to pay an additional amount based on a proportion of an employees salaries and wages (currently 9%) into a complying
superannuation fund.
2
http://www.asx.com.au/documents/research/nancial_sector_factsheet.pdf.
1815-5669/$ - see front matter 2013 Elsevier Ltd. All rights reserved.
http://dx.doi.org/10.1016/j.jcae.2013.03.003
84
N.B. Tao, M. Hutchinson / Journal of Contemporary Accounting & Economics 9 (2013) 8399
problematic for nonnancial rms because one rms failure will not affect a diversied investors portfolio in any directional 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 nancial sector. The failure of a systemically important nancial rm increases the likelihood that other nancial rms will fail due to the cascading effects from the contraction of the nancial sector such as occurred in the Global Financial Crisis. Consequently, monitoring excessive risk-taking by management is particularly important in the nancial sector. The
risk management committee and the compensation committee are both responsible for monitoring and oversight of rms riskrelated activities. Thus, a compensation or risk committee that reduces excessive risk-taking and the probability of the failure of
a systemically important nancial rm will benet diversied shareholders.
This paper investigates the association between the risk management committee (RC) and compensation committee (CC)
and the risk and performance level of nancial rms. We suggest that certain characteristics of committees (size, composition and function) reect 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 rms experiencing increasing levels of risk require a RC and CC that manage and monitor risk to ensure a positive 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 rm. Using a principal components analysis we derive a factor score for the characteristics 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 nds a positive association between risk and performance when committee members 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 rms risk exposure and the proportion of risk-taking incentives in compensation packages. Subsequently, more informed decisions result in a positive association 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 rm with monitoring the riskiness
of compensation packages. Literature on dual committee membership is limited to theory and minimal analysis (Chandar et al.,
2012; Hoitash and Hoitash, 2009; Laux and Laux, 2009). Co-ordination between RC and CC functions reduces information asymmetries which affect rm performance. While some research establishes that board committees improve the performance of
the rm (e.g., Klein, 1998), there is little research into these committees in Australian companies, and in particular their effect
on risk and rm performance. Unlike the US where establishing an audit, nomination and compensation committee is mandated, there is no mandatory requirement for companies to establish committees in Australian rms (apart from Listing rule
12.7).5 Instead, corporations can choose not to comply with the recommendations as long as they can justify any non-compliance.
Consequently, Australia provides an interesting setting to explore the costs and benets of board sub-committees.
Further, nancial sector rms (banks, diversied nancial 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 rms (Wallace and
Kreutzfeldt, 1991) which causes generalisability and transferability problems. In that regard the Australian Prudential Regulation Authority (APRA, 2009) has implemented a framework which regulates nancial institutions (see Appendix A). Prudential Standard APS 510 outlines the skills, knowledge and experience requirements for directors involved in risk
management.6
In recent years, many banks and nancial 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 nancial crisis, said to be a result of irresponsible risk-taking by nancial institutions (Pathan, 2009). This study contributes to the literature as there is a paucity of research on whether the compensation and risk management practices of the nancial sector
are associated with the level of risk and related return. Given that the adoption of RC and CC by Australian companies is voluntary, it is not surprising that the inuence of these committees has not been fully explored.
The paper proceeds as follows. In Section 2 we review the relevant literature and present a number of hypotheses. Section 3 describes the research methodology and Section 4 provides the results of the analysis. The nal section provides a
summary and conclusion.
2. Background and hypothesis development
Financial rms have become large, complex organisations involving signicant delegation of decision-making and risktaking responsibility. Consequently, it is difcult 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 rms as bank failure has more signicant costs.
We exclude committee size from the principal components analysis as research nds 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 its
legal and prudential obligations, and to ensure that the regulated institution is managed in an appropriate way taking into account these risks (APS 510: 3).
4
85
sectors, Andres and Vallelado (2008) suggest that information asymmetries in the nancial 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 difculty in determining the quality of loans, opaque nancial engineering,
complicated nancial statements, investment risk is easily modied, or perquisites are easier for managers to obtain (Levine,
2004). Within a framework of limited competition, intense regulation, and higher informational asymmetries the board becomes a key mechanism to monitor managers behaviour and to give advice on risk management, strategy identication 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, provide information and counsel to managers, monitor compliance with applicable laws and regulations, and link the corporation 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 measuring a boards efcacy. The board of directors delegates some of its authority to specic 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 specic 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 inuence over corporate performance (Klein, 1998), corporate
strategy (Vance, 1983) and reducing agency problems (Davidson et al., 1998) than the entire board. Consequently, committees are important in rms where agency costs are high, for example, high risk, leverage, complexity and large size. Furthermore, agency theory suggests that characteristics such as its independence and an independent chairperson are potential
factors inuencing committee effectiveness (Bradbury, 1990; Carson, 2002).
2.1. Risk monitoring in the nancial sector: the risk and compensation committee
The risk management committee monitors the level of risk the rm is exposed to while keeping in mind the desire to
maximise returns. The RC advises the board on the rms management of the current risk exposure and future risk strategy
(Walker, 2009). The compensation committee oversees remuneration practices which are designed to attract and retain
employees. 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 rm 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 rm (Murphy, 2000).
According to signalling theory (Certo, 2003) organisations disclose good corporate governance practices, such as committee formation, to create a favourable image in the market. This, in turn, minimises any potential rm devaluation by investors or maximises the potential for rm 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 rm (Akhigbe and Martin, 2006). Committee directors specic knowledge of the complexity of the nancial
sector enables them to monitor and advise on their area of responsibility.
Factors determining the governance efcacy of the compensation, risk and audit committees are similar as they are monitoring committees of the board. This research examines the governance efcacy of the RC and CC based on four characteristics which were identied by Xie et al. (2003) as contributing to audit committee effectiveness.7 First, to full their
monitoring role, the committees need to be independent of company management. The ASX CGC recommends that the compensation committee should consist of a majority of independent directors (ASX CGC, 2007, p. 35). This recommendation reects 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 sufcient 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 monitor risk is related to length of service on the board or in the nancial 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 specically handle agency issues (Xie et al., 2003).
86
frequent meetings allow potential problems to be identied, 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 expected to reduce managers risk adverse behaviour. Pathan (2009) suggests that strong board monitoring is positively associated with bank risk-taking based on the view that bank shareholders have incentives for more risk and nds 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 rm 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 rms risk appetite. In other words, we do not
expect a positive association between RC composition and rm 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 representative of shareholders interests. Consequently, there will be a positive association between CC characteristics and rm 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 nancial rms.
H1b. The composition of the risk committee is negatively associated with the risk level of nancial rms.
2.2. Directors dual membership on the RC and CC
While Bradbury (1990: 22) argues that audit committees reduce information asymmetry between insiders and outsiders
of the rm, 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 committee is to determine the appropriate level of risk the rm should take while the compensation committee may design
remuneration packages with the purpose of increasing managers risk-taking. Therefore, it seems apparent that these committees should co-ordinate and communicate when making decisions.
Board committees often work independently to achieve their own objectives. However, there are cases where different
committees 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 executives pay structure. Specically, the model developed by Laux 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 nancial 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 nd 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 predicts that managers who are compensated based on rm 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 efcacy should also mean higher risk. However, certain compensation
policies may encourage excessive managerial risk-taking rather than investing rm resources in a risk-neutral manner
(Miller et al., 2002).
Asset pricing theories suggest that no level of risk is excessive for diversied shareholders in non-nancial rms because
the failure of one rm does not adversely affect their diversied portfolio. However, Gordon (2011, p. 5) suggests that shareholders in the nancial sector prefer less risk as the failure of a systemically important nancial rm will reduce the value of
a diversied shareholders portfolio from the subsequent increase in the systematic risk-bearing premium. In addition, research suggests that instead of looking at risk management from a silo-based perspective, rms that take a holistic view
of risk management will improve rm performance (Gordon et al., 2009).8 Consequently, communication and co-ordination
between the RC and the CC is important for rms in the nancial sector and means that directors with multiple committee
membership are likely to act more conservatively to avoid excessive risk-taking and the threat of rm failure.
Therefore, when setting the incentive payment policy the compensation committee must consider whether their policy
ts within the rms 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.
87
committees (Raber, 2003). As directors have specic 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 compensation 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 rm performance
According to asset pricing models a rational investor should not take on any diversiable risk (unsystematic risk or idiosyncratic risk), as only non-diversiable (systematic or market) risk (beta) is rewarded. A sufciently diversied portfolio
limits the risk exposure to systematic risk only and the level of systematic risk is not affected by the failure of any one rm.
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 nancial sector is the dening factor in rewarding the systematic exposure taken by an investor (Bodie
et al., 2009). Consequently, the failure of a systemically important nancial rm will increase the likelihood that other nancial rms will fail (Gordon and Muller, 2011) and lowers the expected return in the nancial sector (Gordon, 2011). Gordon
and Muller (2011) suggest that shareholders in the nancial sector internalise, at least partially, the consequences of rm
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 default which in turn leads to lower returns.
Studies of the association between committee composition and nancial performance of non-nancial rms are mixed, failing to nd any signicant relationship (Ellstrand et al., 1999), nding a negative association (Klein, 1998), or nding a positive
association (Young and Buchholtz, 2002). Reeb and Upadhyay (2010), in a study of eleven types of committees in non-nancial
rms, nd that the nance, corporate governance, public issue/diversity committees are positively associated with performance (Tobins Q). Adams and Mehran (2008) nd that the number of committees is negatively associated with Tobins Q 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 between risk management and rm-related characteristics. Following this train of thought, we do not expect a direct relationship between CC or RC composition and rm performance9. Instead, we posit that in situations of high uncertainty, such as
high levels of risk, rms need committees that are competent in managing and monitoring risk. Firm risk refers to the underlying volatility of rms earnings and has been identied as a source of agency conict (Bathala and Rao, 1995). Firm risk, as a
measure of the rms information environment and the risk of its operating environment, is also a potentially important determinant of rm performance. In an effort to reduce these risks rms 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 sufcient monitoring of managerial behaviour and to curb excessive risk-taking.
The efcacy 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 rm 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 association 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 we
expect 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 to Gordons (2011, p. 6) suggestion that even though shareholders may not
internalize all of the costs of systemic distress. . . their internalized losses are sufcient to justify appropriate measures to
control nancial rm 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
rms risk appetite and subsequently is associated with better rm performance? Consequently, committees provide monitoring 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) nd that a positive association between future rm performance and stock option grants depends on increasing
compensation committee quality.
88
3. Method
3.1. Sample selection
The nancial sector in 2008 consists of 265 rms listed on the Australian Securities Exchange (ASX, 2010). The sector includes diversied nancials, banks, insurance, real estate companies and real estate investment trusts. Financial sector companies 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 317
ASX listed rms in the nancial sector for the years 2006 to 2008 (711 observations) based on the availability of the relevant
data. Archival data on rms 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 rms 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 rms) with a risk committee, 337 (156 rms) with a compensation committee, and 185
observations (96 rms) with both committees for testing the hypotheses.
3.2. Research model
There are two dependent variables in this study: risk (BETA) and rm performance (LNEPS). Our principal measure of risk
is beta. Beta is the slope coefcient 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
coefcient 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 deviation of rm daily stock returns for each scal 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 rm performance has been widely studied by researchers in business management,
economics, accounting and nance. Asset pricing models generally specify that shareholders are compensated for bearing
risk by receiving higher returns. Although there are various measures of rm performance used in prior research, this study
uses the rms earnings per share (EPS) because (1) income-based risk is used in the analysis and EPS also reects the income
of the rm, (2) EPS is likely to be inuenced by the rms managerial risk-taking behaviours which is the emphasis of this
study and (3) it is a performance measure that is common amongst all nancial rms thus allowing comparability. Prior research has also used this measure of nancial performance in the nancial 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 appropriate 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 to Petersens (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 rm effect can vary both spatially and temporally. We include dummy variables for each
period (to absorb the time effect) and then cluster by rm.
The denitions of the individual independent and control variables are reported in Table 1. The models are run separately
for each committee; otherwise the analysis would only include rms that have both committees. The risk and compensation
committee models follow
BETA b0 b1 COM FACt b2 COMSIZEt b3 COM CEOt b4 LNEPSt1 b5 LNASSETSt b6 LEVERAGEt

b7 BSIZEt b8 YEARt b9 SEGMENTt e
BETA b0 b1 DUALt b2 RCCEOt b3 LNEPSt1 b4 LNASSETSt b5 LEVERAGEt b6 BSIZEt b7 YEARt

b8 SEGMENTt e
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.
89
Table 1
Denition of variables.
Variable
Dependent variables
BETA
LNEPSt+1
Measurement
Market risk is the slope coefcient the companys equity rate of return adjusted for thin trading
The natural log of reported net prot 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 efcacy
COMFAC
Principal components factor analysis of the following ve components
CC/RC IND
Percentage of independent directors to total directors on the committee
CC/RCPRO
Percentage of directors with professional qualication 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 has P10 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
COMSIZEBETA
DUALBETA
Interaction of COMFAC and BETA

Interaction of COMSIZE and BETA
Interaction of DUAL and BETA
Control variables
COMCEO
LNEPSt
LNASSETS
LEVERAGE
BSIZE
YEAR
SEGMENT
Dummy variable equals 1 if the CEO is also a member of the compensation or risk committee
The natural log of reported current earnings per share before abnormal items at year t
The natural log of rms total assets in million dollars
The ratio of total liabilities to total assets
The total number of directors on board
Dummy variable for year 2006, 2007, 2008
Dummy variable equals 1 if rm is a bank, diversied nancial, insurance, REIT, or real estate; 0 otherwise
LNEPSt1 b0 b1 COM FACt b2 COMSIZEt b3 BETAt b4 COM FACt BETAt b5 COMSIZE BETAt b6 COM CEOt
b7 LNEPSt b8 LNASSETSt b9 LEVERAGEt b10 BSIZEt b11 YEARt b12 SEGMENTt e
LNEPSt1 b0 b1 DUALt b2 BETAt b3 DUAL BETAt b4 RCCEOt b5 LNEPSt b6 LNASSETSt

b7 LEVERAGEt b8 BSIZEt b9 YEARt b12 SEGMENTt e
3.2.1. Independent variables

In order to communicate effectively and avoid the problem of diffusion of responsibility, the committee should be relatively 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 increases, 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 composition using a principal components analysis of ve 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 t well with the factor solution and should be dropped from the analysis. Using a factor score is attractive because it extracts a component that is common to ve committee characteristics. The rationale for the committee characteristics 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. Justication for the components of the factor score follow.
Committee independence (CC/RCIND) is assessed according to compliance with the ASX CGC (2007: 16) denition 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 activity
using meeting frequency (CC/RCMEET) as a proxy.
90
Regulators have called for more nancial experts on boards following the recent global nancial crisis and the increased
incidence of accounting scandals (Gner et al., 2008). The basic assumption is that directors with a better understanding of
nancial principles and standards will be better equipped to full their monitoring role of risk avoiding behaviour. The professional expertise of individual committee members (CC/RCPRO) is measured by identifying professional qualications in
accounting or nance (e.g., Certied Practising Accountant (CPA), Chartered Accountant (CA) or Chartered Financial Analyst
(CFA)). This measure is consistent with that of Petra and Dorata (2008) and Sapp (2008) who examine the relationship between 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 rm-specic 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 with Sun et al. (2009). We also
measure committee expertise based on members industry experience. Directors with longer tenure in the nancial sector
would have superior experience in determining an appropriate risk appetite for the company. Therefore, we use the proportion 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 identies 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 rm size is likely to lead to greater performance, while rm size is negatively associated with rm risk (Pathan, 2009). We perform a natural log transformation of the
variables of EPS and rm 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 protability.
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 nancial sector nds a negative association between board size and rm 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 benet 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 rm. On the other hand, the CEO
may be motivated to act opportunistically, undertaking such activities as empire building and excessive or unrelated diversication (Baysinger and Hoskisson, 1990), leading to increased levels of risk. We also control for year (YEAR) and sector segments (SEGMENT). Different segments may be subject to different regulations and therefore may not be an homogenous
group for testing the hypotheses.
4. Results
Table 2 reports the descriptive statistics for the variables related to risk, rm characteristics, rm performance and compensation and risk committees. Of the 711 observations, 47% disclose the existence of a CC in their annual reports. Only 33%
of the sample rms 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),
nancial companies commonly choose not to establish such committees.
The beta coefcient has a mean of 1.27, indicating a high level of market risk facing nancial rms 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 nancial rms. 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 nance professional qualications. 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.
Table 2
Descriptive statistics.
Variable-continuous
2006 (N = 219)
2007 (N = 244)
2008 (N = 248)
Median
Std. dev.
Mean
Median
Std. dev.
Mean
Median
Std. dev.
Mean
Median
Std. dev.
1.274
10.60
3.20
75.13%
73.22%
21.93%
0.284
2.911
3.61
80%
75.10%
13.10%
0.322
4.75
25.480
5.54
11,055
0.547
0.95
8
3
75%
75%
0%
0.333
2
3
93%
81.50%
0%
0.330
4
8.6
5
184
0.410
1.840
8.123
0.937
26%
28.44%
28.74%
0.288
1.997
1.429
24.10%
28.77%
23.81%
0.277
2.496
71.165
2.021
59,583
0.816
1.255
10.325
3.19
77.27%
68.44%
24.10%
0.264
3.19
3.97
79.61%
72.8%
15.4%
0.304
5.38
30.442
5.45
10,191
0.465
0.820
7.7
3
75 %
67%
0%
0.25
3
4
75%
74%
0%
0.330
5
13.6
5
159
0.370
1.915
8.355
0.981
24.02%
25.76%
29.40%
0.274
1.870
1.657
22.44%
26.18%
23.75%
0.243
2.859
58.99
1.945
51,958
0.405
1.102
9.709
3.280
75.03%
68.86%
19.38%
0.250
2.85
3.6
78.65%
72.18%
12.48%
0.294
4.44
35.763
5.62
10,603
0.721
0.89
6.9
3
75%
67%
0%
0.25
2
3
81.50%
75%
0%
0.330
4
14.6
5
174
0.46
2.049
7.801
0.923
24.7%
28.70%
26.15%
0.259
2.074
1.448
25.55%
30.47%
22.02%
0.264
2.389
66.484
2.027
578,168
1.266
1.464
11.722
3.14
73.45%
81.35%
22.65%
0.333
2.74
3.40
81.50%
79.05%
12.16%
0.360
4.63
10.715
5.55
12,272
0.448
1.210
8.9
3
75%
100%
0%
0.330
2
3
100%
100%
0%
0.330
4
2.0
5
191
0.40
1.509
8.131
0.916
28.75%
28.68%
30.58%
0.319
2.011
1.212
24.05%
28.65%
25.45%
0.307
2.286
82.595
2.085
67,360
0.366
Variable-dichotomous
Coding
Observations
% of sample
Coding
Observations
% of sample
Coding
Observations
% of sample
Coding
Observations
% of sample
CCEXT
COMCEO(CC)
RCEXT
COMCEO(RC)
DUAL
1
1
1
1
1
337
42
236
25
185
47
6
33
3.5
26
1
1
1
1
1
98
12
60
6
49
44.3
5.4
27.1
2.7
22.2
1
1
1
1
1
118
12
82
8
58
47.6
4.8
33.1
3.2
23.4
1
1
1
1
1
121
18
94
11
58
48.6
7.2
37.8
4.4
23.3
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 the committee; CC/RCSENIORIND: percentage of
directors with P10 years industry services divided by total directors on the committee; CC/RCSENIORBoD: 1 if a committee has member P10 year board service and 0 otherwise; CC/RCPRO: percentage of directors
with professional qualication divided by total directors on the committee; CC/RCMEET: number of meetings the committee held per year; EPSt: reported current earnings per share before abnormal items at year
t; BSIZE: the total number of directors on board; ASSETS: rms total assets in million dollars; LEVERAGE: the ratio of total liabilities to total assets; CCEXT/RCEXT: dummy variable equals 1 if the rm has a CC/RC; 0
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 CC and RC; and 0 otherwise.
BETA
STD.DEV
COMSIZE(CC)
CCIND
CCSENIORIND
CCSENIORBoD
CCPRO
CCMEET
COMSIZE(RC)
RCIND
RCSENIORIND
RCSENIORBoD
RCPRO
RCMEET
EPSt
BSIZE
ASSETS($million)
LEVERAGE
ALL YEARS (N = 711)

Mean
91
92
Table 3
(a) Details of the sample. (b) Probit regression-unbalanced data.
(a)
All years
Observations
Insurance
Bank
Real estate
REIT
Diversied nancial
Total
2006
%
2007
Observations
Observations
2008
%
Observations
24
43
120
145
3.4
6.1
16.9
20.4
10
16
37
45
4.6
7.3
16.9
20.5
4
11
34
55
1.6
4.5
13.9
22.5
11
15
49
45
4.4
6.0
19.8
18.1
379
711
53.2
100%
111
219
50.7
100%
140
244
57.4
100%
128
248
51.6
100%
(b)
Constant
BETA
LNEPSt
LNASSETS
LEVERAGE
BSIZE
YEAR
BANKS
DIVERSIFIED
INSURANCE
REIT
REALESTATE
Pseudo R2
Chi2
N
RCEXT
CCEXT
DUALEXT
7.545
0.133
0.505
0.124
0.072
0.163
Yes
0.140
0.165
1.040
0.239
0.341
0.179
161.19
711
(1.13)
(3.80)***
(0.52)
(4.36)***
(1.13)
(4.51)***
25.022
0.104
3.224
0.113
0.113
0.169
Yes
0.539
0.565
0.681
0.594
0.487
0.163
160.79***
711
(3.64)***
(3.28)***
(3.24)***
(4.08)***
(1.49)
(4.80)***
12.325
0.041
3.273
0.171
2.118
0.208
Yes
5.703
4.817
Omitted
4.715
5.291
0.260
34.09***
185
(0.03)
(0.42)
(2.04)***
(1.80)*
(2.84)**
(2.38)**
(0.17)
(0.20)
(1.08)
(0.29)
(0.41)
(0.56)
(0.60)
(0.69)
(0.63)
(0.51)
(0.01)
(0.01)
(0.01)
(0.01)
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
rms 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.
In relation to the risk committee characteristics, the average membership is 3.61.14 Members of the RC are primarily independent 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 qualied in accounting and/or 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 rm characteristics and rm 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 nancial rms has, on average, total assets of $11,055 million and leverage of 0.55. EPSt has a mean of 25.48. Overall, there are
no apparent or signicant differences in characteristics of nancial rms 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 rms: 24
insurance companies (3.4%), 43 banks (6.1%), 120 real estate rms (16.9%), 145 real estate investment trusts (20.4%) and
379 diversied nancial companies (53.2%).
Consistent with prior research (e.g., Subramaniam et al., 2009) our rst test is to determine the characteristics of nancial
rms with these committees. The results reported in Table 3b from the probit regressions show a positive association between the existence of the committees (RC and CC) and the size of the rm, the size of the board and the level of risk (BETA).
This result suggests that rms with more inherent risk set up these committees to monitor and manage risk more closely.
Leverage is not signicantly associated with the existence of the committees. Performance (LNEPSt) is positively and significantly associated with the existence of a CC. The sector of the nance industry is not signicantly associated with forming a
CC or RC.
14
There are three RC that have only one member.

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 rms do not belong to the group of six rms 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.
15
93
Table 4
Common factor analysis of the measures of committee efcacy (N = 337 rms with CC; N = 236 rms with RC).
Panel A: Estimated communalities of ve measures of committee efcacy

Committee independence
Proportion of committee with 10 or more years experience in the nancial industry
Proportion of committee directors with 10 or more years experience on the board
Proportion of committee directors with an accounting and/or nance qualication
Committee meeting frequency
Component
Panel B: Eigenvalues of the reduced correlation matrix of committee efcacy measures

Proportion of committee with 10 or more years experience in the nancial industry
Proportion of committee with 10 or more years experience on the board
Proportion of committee with an accounting and/or nance qualication
CC
RC
0.448
0.660
0.236
0.560
0.575
0.704
0.716
0.674
0.649
0.780
Eigenvalues
Total CC
Cumulative % CC
Total RC
Cumulative % RC
1.325
1.153
0.994
0.833
0.694
26.509
49.577
69.458
86.119
100.000
1.381
1.122
1.020
0.856
0.621
27.616
50.052
70.450
87.578
100.000
Panel C: Correlations between the common factor and ve committee efcacy measures
Factor score
Proportion of committee directors with 10 or more years experience in the nancial industry
Proportion of committee directors with 10 or more years experience on the board
Proportion of committee directors with an accounting and/or nance qualication
CC
RC
1
0.669***
0.003
0.466***
0.087
0.756***
1
0.284***
0.116*
0.338***
0.257***
0.877***
p < 0.05.
p < 0.10.
***
p < 0.01.
*
4.1. Common factor analysis for committee efcacy

The results of the factor analysis are presented in Table 4. Panel A shows the estimated communalities for each of the ve
committee efcacy measures. Panel B presents the eigenvalues of the reduced correlation matrix of the ve committee efcacy measures. Panel C presents the correlations between the common factor and the ve measures of committee efcacy.
The extracted components explain nearly 50% of the variability in the original ve variables.
4.2. GLS regression results

The results of testing H1 are reported in Table 5. The results show a positive and signicant association between the CC
characteristics and risk (B = 0.229; z = 2.61), thus supporting H1a. We also nd a marginally signicant 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 signicantly associated with rm
performance (LNEPSt) which suggests that excessive risk-taking is associated with lower rm performance. In other words,
excessive risk-taking increases the probability of failure. Hypothesis 2 posits that directors dual membership on the compensation 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 signicant, thus failing
to support H2.
The results for testing H3a and H3b are reported in Table 6. We fail to nd that a positive association between risk and
performance depends on the characteristics of the RC or the CC. However, we nd 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 membership and risk is positively and signicantly associated with performance (B = 0.011; z = 2.15), supporting H3b. While testing the hypotheses, we discovered that many 2008 rms 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
signicant.
In this paper we do not posit a basic relationship between committee composition and rm performance. Such an association is open to the criticisms of endogeneity of the variables because committee composition can affect rm performance
and rm 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 between excessive risk and performance. We control for potential endogeneity by using instrumental variables that are related
to committee composition but are not related to performance in year t + 1 and run a 2SLS regression. The instrumental vari-
94
Table 5
Random effects GLS regression with cluster robust errors dependent variable: market risk (BETA).
Variables
Committees
Predicted
Compensation
Sign
Risk
z
B
***
Constant
COMFAC(CC)
COMFAC(RC)
COMSIZE(CC)
COMSIZE(RC)
DUAL
?
+

?
?
42.50
0.229
(3.31)
(2.61)***
0.011
(0.12)
Control variables
COMCEO(CC)
COMCEO(RC)
LNEPSt
LNASSETS
LEVERAGE
BSIZE
YEAR
BANK
DIVERSIFIED
INSURANCE
REIT
REALESTATE
?
?
+
+
+
+
?
?
?
?
?
?
0.090
(0.34)
6.114
0.085
0.185
0.088
Yes
0.326
0.267
Omitted
0.327
0.305
(3.18)***
(1.16)
(3.19)**
(1.34)
R2
Wald chi
N
Firms
0.150
42.49***
336
157
(0.89)
(0.81)
(1.03)
(0.87)
Dual
z
***
41.34
(3.08)
0.235
(1.68)*
0.146
(1.28)
0.184
5.800
0.139
0.121
0.111
Yes
0.705
0.991
Omitted
1.073
0.858
0.199
61.66***
235
126
(0.43)
(2.83)***
(1.68)*
(1.33)
(1.40)
(0.84)
(1.26)
(1.36)
(1.05)
39.05
(2.81)***
0.423
(0.79)
0.299
5.664
0.130
0.077
0.163
Yes
1.167
0.806
Omitted
0.827
0.949
(0.61)
(2.62)***
(1.27)
(0.87)
(1.64)
(2.86)***
(3.53)***
(2.73)**
(2.84)***
0.177
146.34***
185
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 the CC and RC and 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 year t; LNASSETS: the natural log of rms 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.
ables which are regressed against the existence and composition of the committees in the rst stage are: LIABILITIESt (total
liabilities), CFOt1 (cash ows 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 rms establishing committees (Bradbury,
1990; Carson, 2002; Piot, 2004;Ruigrok et al., 2006; Subramaniam et al., 2009; Yatim, 2010). Furthermore, using the one period lag variables (LIABILITIESt and BSIZEt) and the two period lag variables (CFOt1 and STD.DEVt1) means the instrumental
variables are unlikely to be related to the lead variable of performance (LNEPSt+1) and further reduces the extent of endogeneity (Doucouliagos et al., 2007). The models are run separately for each committee; otherwise the analysis only includes
rms with both committees and reduces the sample to 146 observations.
The results of the 2SLS regressions are reported in Table 7. First, we test whether the existence of a RC, CC, or dual membership are associated with rm performance while controlling for endogeneity. The results show that the existence of the
RC and CC are positively and signicantly associated with rm 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 rm performance is not signicant (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 signicant 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 rm performance increases
when the risk and compensation committees consist of members who are independent of management, have industry
and board experience, are professionally qualied and meet frequently.
Turning our attention to the interaction terms, contrary to our prediction we nd 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 conicts with Yeh et al., 201118 who nd that committee independence curbs excessive risktaking behaviour and improves rm performance particularly during a crisis period (20072008).
18
Yeh et al. (2011) investigated the association between committee (audit, compensation, risk and nomination) independence and performance of the 20
largest nancial institutions from Australia, Canada, France, Germany, Italy, Japan, United Kingdom, and United States in the years 20052008.
95
Table 6
Random effects GLS regression with cluster robust errors dependent variable: performance (LNEPSt+1).
Variable
Committees
Predicted
Main effects
Sign
Constant
COMFAC(CC)
COMFAC(RC)
COMSIZE(CC)
COMSIZE(RC)
DUAL
BETA
COMFACBETA(CC)
COMSIZEBETA(CC)
COMFACBETA(RC)
COMSIZEBETA(RC)
DUALBETA
?
+

?
?

+
?
+

+
Control variables
COMCEO(CC)
COMCEO(RC)
LNEPSt
LNASSETS
LEVERAGE
BSIZE
BANK
DIVERSIFIED
INSURANCE
REIT
REALESTATE
?
?
+
+

?
?
?
?
?
?
R2
Wald chi
N
Firms
6.81
0.001
0.190
0.000
0.001
0.000
0.004
0.008
0.008
0.007
0.010
0.405
554.98***
612
267
Compensation
z
B
***
(37.89)
(1.81)*
(7.14)***
(0.08)
(0.44)
(0.33)
(1.76)*
(6.04)***
(5.44)***
(4.93)***
(4.78)***
Risk
z
***
6.783
0.003
(36.74)
(1.07)
0.004
(1.49)
0.009
0.003
0.003
(2.36)**
(1.46)
(2.84)***
0.003
(0.97)
0.189
0.001
0.000
0.000
0.004
0.003
Omitted
0.003
0.002
(6.85)***
(0.75)
(00.19)
(0.53)
(0.58)
(0.45)
0.506
196.92***
289
130
(0.45)
(0.34)
Dual
6.508
(22.95)
6.56
(25.93)***
0.000
(0.11)
0.002
(0.47)
0.009
(1.07)
0.004
0.013
(0.38)
(2.87)***
0.002
0.002
(1.63)
(0.67)
0.011
(2.15)**
0.008
0.224
0.001
0.005
0.000
Omitted
0.001
Omitted
0.001
0.002
(0.76)
(5.89)***
(0.65)
(0.66)
(0.31)
0.006
0.234
0.000
0.005
0.000
0.005
0.001
Omitted
0.000
Omitted
0.534
111.12***
190
103
(0.94)
(5.64)***
(0.04)
(0.67)
(0.10)
(0.58)
(0.28)
(0.02)
(0.12)
(0.15)
(0.24)
0.60
273.00***
146
76
LNEPSt+1: reported net prot 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 CC and 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 the CEO is also a member of the CC(RC); LNEPSt: reported current earnings per share before abnormal items at year t; LNASSETS: the natural log of
rms 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.
*
p < 0.10.
**
p < 0.05.
***
p < 0.01.
The results in Table 7 show a positive association between risk and performance for rms with directors who have dual
membership on the risk and compensation committee. We nd that the interaction of the DUAL with BETA is positively associated with performance (B = 0.055; z = 3.39). This result supplements the research by Laux and Laux (2009) and recent research by Chandar et al. (2012) who nd that rms with overlapping committee members on the audit and compensation
committee are associated with lower earnings management. BETA is consistently negatively and mainly signicantly associated with rm performance suggesting that increasing levels of risk increase the probability of failure, particularly in the
period leading up to the global nancial crisis of 2008.
The conjecture from this result is that nancial rms 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 justies 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 rm
and the risk-taking incentives of the compensation package. This result also implies that even though separation of committees may help individual committees to focus on their specic tasks, co-operation between the compensation and the risk
committee is advantageous for nancial rms (in terms of improving rm performance). Thus, the collaboration between
these committees lowers information asymmetry and improves monitoring of compensation and risk levels which, in turn,
improves rm performance.
We also ran the 2SLS regression with clusters on rm 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
18
Yeh et al. (2011) investigated the association between committee (audit, compensation, risk and nomination) independence and performance of the 20
largest nancial institutions from Australia, Canada, France, Germany, Italy, Japan, United Kingdom, and United States in the years 20052008.
96
Table 7
Instrumental variables (2SLS) regression: dependent variable: performance (LNEPSt+1).
Variables
Constant
CCEXT
Committees
Compensation
Risk
Dual
Compensation
Risk
Dual
8.145
(440)***
0. 076
(5.13)***
8.129
(472)***
8.000
(216)***
8.138
(283)***
8.114
(208)***
8.116
(216)***
RCEXT
0. 057
(4.10)***
DUAL
0.042
(1.57)
0.060
(2.43)**
COMFAC(CC)
0.042
(4.31)***
0.003
(0.77)
COMSIZE(CC)
COMFACTOR(RC)
0.052
(2.41)**
0.001
(0.15)
COMSIZE(RC)
COMFACBETA (CC)
0.016
(2.41)**
0.001
(0.47)
COMSIZE BETA (CC)

COMFACBETA (RC)
0.017
(3.85)***
0.001
(0.60)
COMSIZEBETA (RC)
DUALBETA
BETA
LNASSETS
LEVERAGE
GROWTH
N
Wald chi2
0.005
(4.03)***
0.003
(2.57)***
0.003
(1.68)*
0.000
(0.16)
0.003
(3.59)***
0.001
(1.37)
0.002
(1.25)
0.001
(0.91)
0.008
(4.15)***
0.005
(4.49)***
0.005
(1.42)
0.001
(0.65)
0.010
(1.26)
0.000
(0.02)
0.001
(0.57)
0.001
(0.52)
0.003
(0.35)
0.001
(0.27)
0.003
(0.64)
0.001
(0.50)
0.055
(3.39)***
0.061
(3.84)***
0.004
(3.01)***
0.002
(0.49)
0.001
(0.41)
612
44.04**
612
40.84***
146
42.64***
289
53.91***
190
27.04***
146
37.80***
LNEPSt+1: reported net prot after tax before abnormal items during the year plus 1;RC/CCEXT: dummy variable equals 1 if the rm has a RC/CC; and 0
otherwise; DUAL: 1 if there is a member who serves on the CC and 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 characteristicsBETA; 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 rms 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 nancial year divided by shareholders equity per share.
*
p < 0.10.
**
p < 0.05.
***
p < 0.01.
Table 8
Tests of endogeneity of: COMFAC(CC/RC), DUAL.
H0
Regressors are exogenous

WuHausman F test:
DurbinWuHausman chi-sq test:
4.040
12.813
F(3, 126)
Chi-sq (3)
p = 0.009
p = 0.005
DurbinWuHausman (DWH) tests and the WuHausman (WH) statistic test the null hypothesis on the regressors (COMFAC(CC), COMFAC(RC) and DUAL). The tests estimate the model parameters within the ordinary least square (OLS) and twostage least square (2SLS) frameworks, and calculates the degree of variation between the OLS and 2SLS coefcients. 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
signicant 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 have
corrected for it. We can infer this as the 2SLS estimates are signicantly different from the OLS estimates.
97
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 computed 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 signicant while the
individual RC characteristics are not signicant.
5. Conclusion
This study provides some illumination towards the importance of corporate governance mechanisms as well as the management of risk in Australian nancial 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 rms in the nancial sector over the period 20062008 provides some evidence of the importance of committees in managing risk to improve rm performance. The
ndings 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 qualied and meet frequently. More
importantly, this study nds that when committee members serve on both the risk committee and the compensation committee the rms level of risk exposure is monitored more closely so that there is a positive association with risk and performance. This result suggests that coordination and communication problems are alleviated when committee members
responsibilities transcend tasks. Future research could investigate this nding further by interviewing risk and compensation
committee members.
This study is the rst to examine the relationship between corporate governance controls (i.e., compensation and risk
committee) and risk management in Australian nancial companies. Practical implications of the study include the demonstration of the benets 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:
Specic 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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Role of risk and compensation committees in managing financial firm risk

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Corporate governance and risk management: The role of risk

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

BETA b0 b1 COM FACt b2 COMSIZEt b3 COM CEOt b4 LNEPSt1 b5 LNASSETSt b6 LEVERAGEt

BETA b0 b1 DUALt b2 RCCEOt b3 LNEPSt1 b4 LNASSETSt b5 LEVERAGEt b6 BSIZEt b7 YEARt

Interaction of COMFAC and BETA

LNEPSt1 b0 b1 DUALt b2 BETAt b3 DUAL BETAt b4 RCCEOt b5 LNEPSt b6 LNASSETSt

3.2.1. Independent variables

3.2.2. Control variables

ALL YEARS (N = 711)

There are three RC that have only one member.

Panel A: Estimated communalities of ve measures of committee efcacy

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

4.1. Common factor analysis for committee efcacy

4.2. GLS regression results

COMSIZE BETA (CC)

Regressors are exogenous

4.3. Robustness testing

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