Internal Controls and Credit Risk in European Banking: The Basel Committee on Banking Supervision Framework Approach

Abstract

Poor corporate governance practices have been cited as contributory to the 2007 global financial crisis. The chapter explores a qualitative self-regulation approach to address a major risk facing banks using the Basel Committee on Banking Supervision (BCBS) framework of internal controls. The study examines the effect of the qualitative principles of the BCBS internal control framework on credit risk. Corporate institutions use internal control frameworks to address the most operational risks, but the current study hypothesizes a possible relation with the credit risk. This research covers banks from selected EU countries covering some period before and after the 2007 financial crisis using a fixed-effect model. We report a significant relationship between board functions and activities, board structure and board monitoring, and credit risk. The results indicate that investment in high-risk assets, bank profitability and board chair being ex-CEO increases credit risk in European banking. The chapter extends the scope of a previous work that used the elements of the COSO internal control framework on a single country. This quantitative measure of qualitative constructs of the framework complements existing research that uses algorithms and simulations to study credit risk.