Board governance and solvency risk: the role of co-opted directors Free

The high propensity for non-risk-averse decisions among corporate and banking executives has faced criticism as a primary contributor to the financial crisis of 2008. Given the adverse economic repercussions resulting from this elevated risk exposure during the crisis, it is imperative to comprehensively investigate and assess the factors influencing and the outcomes stemming from corporate risk management, especially in the banking sector. Further, Basel Accords II and III also require banks to develop and implement a rigorous risk management framework under three Pillars of Basel, more specifically under the “Supervisory review process”, which is the second pillar where the banking regulator in each country monitors the development and implementation of rigorous risk management framework along with corporate governance (BCBS, 2011).

The corporate governance has been examined in terms of two important aspects in literature, that is ownership structure and board structure. Both these aspects play an important role in monitoring internal control mechanisms for firm performance (Nguyen and Vo, 2020; Sial et al., 2019; Vo and Chu, 2019). The corporate governance topics like board composition, board monitoring, board diversity, board independence (Armstrong and Vashishtha, 2012; Chaivisuttangkun and Jiraporn, 2021; Cohen et al., 2013; Coles et al., 2014; Dong et al., 2010) have also been vastly discussed in the literature in terms of the banking sector.

As a financial intermediary and risk transformer, banks risk management strategies significantly dwell upon efficiency of their corporate governance. It is also pertinent to mention that banks have unique attributes that interfere with the way of how usual Corporate Governance mechanisms work, hence the longstanding views on relationship between corporate governance mechanisms and performance do not hold for banks (Fernandes et al., 2018).

It is imperative to note in Australian banking sector, that there is inadequate research on board structure aspects such as board skills, multiple directorships, board size, board meetings, audit committee and board composition. However, the recent literature described instances of banking misconduct that raise questions on how Corporate Governance operates in the Australian banking sector (Outa and Kutubi, 2021). Further, McConnell (2018) argues that there is governance deficit in Australia’s largest banks keeping in view board composition components like size and experience. He argues that higher number of outside directors may cause governance deficit. Therefore, keeping in view corporate governance deficit in Australian banks, the analysis of relationship of board governance in terms of bank risk management in Australian banks becomes absolutely significant. Our study addresses the issue through unique board governance measure of Board Cooption (BCO) and observes its impact on bank solvency risk in banks of Australia as well as New Zealand.

The significance of BCO carries multifaceted implications, as highlighted by Lee et al. (2021a, b) suggesting a noteworthy shift in attention for researchers, corporate managers, shareholders and regulators towards board-cooption and its effects on bank solvency risk. Therefore, we employ cooption measure devised by Coles et al. (2014) in our study. This measure assesses the ratio of “co-opted” directors, denoting those appointed after the CEO assumes office, in relation to the total board size. Boards characterized as “co-opted” or “captured” are commonly linked with a deficiency in board-level independence. Co-opted directors often exhibit a greater propensity to align their allegiance with the CEO responsible for their initial appointment. This alignment can compromise the perceived independence of the board. On the other hand, a co-opted board may adopt a “quiet life” approach, opting to avoid any unnecessary risks (Bertrand and Mullainathan, 2003; Cohen et al., 2013). Consequently, our study aims to scrutinize the influence of BCO on bank solvency risk proxied by the Z-score. We are particularly intrigued by the concept of BCO due to the practical scenario where CEOs are expected to have substantial influence in the appointment of board members (Coles et al., 2014). Simultaneously, our examination of board composition highlights the phenomenon of cooption prevailing in bank governing boards regarding solvency risk.

Along with corporate governance, bank-risks-related literature concludes that solvency risk is more important risk in terms of developing a rigorous bank risk management framework (Almarzoqi et al., 2015; Ghenimi et al., 2017). The corporate governing boards must develop risk management policies or frameworks that must be generally guided under principles of Basel accords including solvency risk which should solve Australian banking industry misconduct issues as well. Acknowledging the significance of solvency risk, the efficient proxy measure of Z-score has been deployed to measure solvency risk. It is a well-known measure in terms of corporate solvency risk or default risk which is used in various studies regarding risk management (Almarzoqi et al., 2015; Zheng et al., 2019) and Corporate Governance (Baghdadi et al., 2020). So, these two terms, solvency risk and default risk, are used interchangeably in our study.

To address the solvency risk issue, corporate governance plays a huge role in developing and implementing risk management policies and frameworks. Such governance is overseen by the board of directors, a collective entity crucial to strategic decision-making (Forbes and Milliken, 1999). The constitution of the boardroom greatly influences the nature and caliber of discussions conducted behind closed doors, thereby exerting a substantive impact on a firm’s choices (Giannetti and Zhao, 2019). The governing boards perform a vital role in making highest level decisions in corporate, there is a compelling interest in exploring how the composition of a board influences a firm’s long-term viability and solvency (Almandoz and Tilcsik, 2016; Dalton and Dalton, 2011; PricewaterhouseCoopers LLP, 2014).

Prudent corporate governance practices are vital for the stable growth of the banking and financial system. The existing literature extensively discusses corporate governance topics like board composition, board diversity and board independence. Further, the relationship of governance and bank risk is discussed in the context of the banking sector (Brewer and Jagtiani, 2013; Santos and Wilson, 2017; Laeven and Levine, 2009); however, BCO is understudied. The significance of BCO carries multifaceted implications, as highlighted by Lee et al. (2021a, b). He suggests a need for a noteworthy shift in attention among researchers, corporate managers, shareholders and regulators towards board-cooption and its effects on bank risks.

Further, the phenomena of cooption have only been studied on limited data of US firms (Baghdadi et al., 2020; Coles et al., 2014; Lee et al., 2021a, b), however, there is no evidence of the existence of such study in the context of any country other than America, for instance, Australia and New Zealand. Moreover, incidents of banking misconduct (Islam and Yahanpath, 2015; McConnell, 2018; Outa and Kutubi, 2021), in the aforementioned countries, particularly invites our attention to address this gap. Our study will have unique contribution to the relevant body of knowledge. Firstly, the relationship between BCO and banks’ solvency risk hasn’t been discussed in the context of Australian and New Zealand banks. Secondly, at a methodological level, this relationship between cooption and solvency risk has never been tested using the Z-score (Solvency risk) through system GMM on panel data from Australia and New Zealand.

Following the abstract and introduction, the remaining sections of our study are Section 2, which briefly presents the literature review regarding cooption and solvency risk. Section 3 encapsulate the data, variable description and methodology details. Section 4 discusses regression results, findings and practical implications. Section 5 elaborates on the conclusion.

The corporate scandals and downfall have raised awareness of corporate governance practices and prompted researchers in the current millennium (Becht et al., 2003). Corporate governance concerns persist as a prominent subject of research worldwide, as the corporate governance landscape offers valuable opportunities to investigate diverse facets of agency-related matters (Cumming et al., 2021). Further, it becomes more significant as we do have evidence of banking misconduct in Australian banks as well (Outa and Kutubi, 2021). Featherstone and Doeksen (2019), raises questions on composition of the board regarding outside directors meeting once a month. These outside part time directors may cause governance deficit. The findings by Staples and Linden (2019) regarding Australian banking misconduct keeping in view Financial Services Commission Royal Commission (FSRC) report explains that insights revealed in this report are shocking. No attention was paid to whistle blowers and no hard questions are asked by directors in fulfilling their duties, causing governance failures and misconduct in Australian banks. Many studies exclude banks arguing the difficulty to obtain data and the high regulatory requirements. Fernandes et al. (2018) that banks have unique attributes that interfere with the way in which the usual CG mechanisms work hence the long-held views on relationship between CG mechanisms and performance do not hold for banks. The few studies have also shown mixed results regarding the role of CG measures in explaining financial performance and loan quality given the deep regulator involvement (Outa and Kutubi, 2021). Therefore, evidence of corporate governance deficit is significant and it invites research and analysis to highlight root causes of this governance misconduct and deficit.

The financial crisis of 2009 emerged due to excessive risks taken by the executives of the banking and corporate executives (Lee et al., 2021a, b).The negative economic impact of excessive risks is a cause for concern. Banking corporations can eradicate excessive risk exposure by ensuring effective corporate governance practices. Risk is also triggered when misconduct instances in banking industry of Australia depicts weak Corporate Governance (Outa and Kutubi, 2021). Banks also face various types of risks, addressed through policies drafted under regulatory risk management guidelines to monitor and manage risks efficiently. Both the Global Financial Crisis (GFC) of 2009 and the Asian Financial Crisis (AFC) of 1997 highlighted the importance of corporate governance in ensuring smooth functioning and risk management, particularly in the banking industry. Additionally, implementing corporate governance is significant for securing stakeholders by integrating the corporation’s rules and functions. It has been observed that the changing landscape requires a transformation of corporate governance practices to keep pace with the times. Therefore, the role of governance needs to be reassessed following the GFC to better manage risks in banks (Brunnermeier et al., 2012).

The corporate governance board stands as the sole legal authority responsible for finalizing firm decisions, as elucidated by Adams and Ferreira (2007). The literature on corporate governance boards has mostly addressed issues like board diversity and composition. However, BCO is a relatively ignored area of research. A few studies establish the governance flaw by analyzing the effect of BCO on corporate dividends, research and development expenditures, firm risk-taking and default risk (Baghdadi et al., 2020; Harris et al., 2019; Huang et al., 2019; Jiraporn and Lee, 2018a, 2018b). However, the literature lacks evidence of an analysis of the relationship between BCO and solvency risk in the global banking sector in general and specifically in context of Australia and New Zealand banking industry.

Extending our discussion regarding board governance, we elaborate that BCO is a novel approach to gauging board quality. According to Coles et al. (2014), Jiraporn and Lee (2018a), Lee et al. (2021a, b) established the concept that coopted directors on board lead to lower or no shareholder dividends. They also dig out that the proportion of coopted directors on the board also leads to holding increased cash flows with the corporation instead of paying the dividend. BCO is an effective measure to gauge board quality or directors’ adherence to the CEO in comparison with the traditional proxy of board independence (Coles et al., 2014; Huang et al., 2021). This substantial adherence to the CEO implies that those coopted directors allow the CEO to be less restricted. This shows that higher BCO indicates superior power of the CEO in the decision-making process (Huang et al., 2021).

All industries, including banks, must take the appropriate measures to manage the risk through effective corporate governance practices to respond to the challenging circumstances on time. When considering coopted directors, their capacity for independence and effective monitoring becomes compromised, given their heightened likelihood of being loyal to the CEO, who played a role in their initial appointment, as noted by Coles et al. (2014). Effective corporate governance mechanisms can mitigate bank solvency risk in the realm of banking corporations.

The literature includes theories on banking stability and regulations, for example agency theory (Stentoft et al., 2016), highlighting the separation of concepts of ownership and control. The divergence in the interests of owners (shareholders) and control (board) is explained by this theory (Shleifer and Vishny, 1997). Therefore, boards operating under the influence of cooption can make risky decisions, endangering the bank’s solvency against the interest of owners (shareholders). Moreover, risk transformation theories propose that a bank also performs a function of risk transformation by establishing a secure deposit base to fund a portfolio of risky loans (Diamond, 1984). The core functions of banks explained under the theory of financial intermediation and risk transformation carry massive innate risk, and the addition of BCO further maximizes the solvency risk. Therefore, corporate governing boards must be well aware of risks faced by banks and relevant policy development and regulatory guidelines to avoid agency conflict.

After elaborating on the theoretical significance of our area of study, we also narrate the link to industry regulation for banking. Several bank risk-related guidelines are issued from time to time like the Basel accord, which is at the core of bank risk management guidelines like the “Supervisory Review Process,” which constitutes the second pillar of Basel II and III and addresses corporate governance and various risks banks face. It mandates that supervisors or central banks review and evaluate whether the aforementioned risks, falling under Pillar II, are being effectively managed. Moreover, the Core Principles of the Basel Agreement are closely linked to the stability of banks (Bitar et al., 2018). Consequently, regulators are compelled to diligently monitor commercial banks’ risk management policies, including measures to control risks and ensure adequate liquidity to prevent bank failures or insolvency. Therefore, it becomes the utmost responsibility of corporate governing boards of banks specifically in Australia and New Zealand to reduce misconduct instances.

Examining the dimensions or sources of financial stability in banks involves analyzing solvency, liquidity and credit risks. This categorization of risks proves valuable when comprehensively analyzing the distinctive aspects of risk management as established by International Monetary Fund (IMF) research literature (Almarzoqi et al., 2015). Therefore, solvency risk is crucial for banks. While corporate governance has been extensively studied, the impact of BCO on bank solvency risk management remains unexplored.

Moreover, Firms with more coopted boards tend to have higher solvency risk due to unpredictable decision-making. Effective decision-making benefits from open discussion and contradicting thoughts (Almandoz and Tilcsik, 2016; Giannetti and Zhao, 2019; Ma and Khanna, 2016). However, with higher proportion of director cooption in a company, the levels of loyalty to CEO will be much higher (Coles et al., 2014). However, the timidity of the coopted director to CEO may elevate default risk (Coles et al., 2014; McDonald and Westphal, 2011; Westphal and Zajac, 1997). Consequently, the increase in coopted directors may elevate default risk due to the lack of conflicting views between them and the CEO.

Further it is pertinent to mention that co-opted director’s behavior is potentially influenced by the notion of loyalty to the CEO who appointed them. They may neglect their fiduciary and ethical responsibilities to stakeholders by enabling the CEO and his relevant team of executives to avoid certain disclosures related to several risks, that is environmental risk, fiduciary matters related risk etc. (Zaman et al., 2025). Therefore, increased presence of co-opted directors may undermine proper risk disclosures. This hinders strategic decision-making, causing increased volatility and uncertainty. This is in line with recent cooption literature, which explain that such directors are associated with weak managerial monitoring (Coles et al., 2014; Zaman et al., 2025), excessive managerial risk-taking (Lee et al., 2021a, b), a reduced likelihood of enforcing claw back provisions (Huang et al., 2019) and excess investment in inefficient research and development (Harris et al., 2019). On the other hand, the behavior of co-opted directors may vary becoming more diligent due to reputational concerns, career considerations and fear of losing legitimacy. Therefore, a significant proportion of co-opted directors may show an inverse behavior which could reduce board-management conflict and enhance management’s commitment to stakeholders, leading to appropriate disclosure. Moreover, Nguyen et al. (2021) also find a positive relationship between corporate innovation and co-opted directors. Similarly, Bhuiyan et al. (2021) and Harris and Erkan (2021) explored that co-opted directors help in decreasing cost of capital and improve earnings management of the company. Therefore, co-opted directors on the board exhibit above explained behaviors and developing an in-depth comprehension about it will help developing efficient risk management strategies.

If we look at scholarly insights on managerial discretion with reference of Finkelstein and Hambrick (1990) and Adams et al. (2005), we observe that managers with authority in decision-making tend to make very risky decisions. We expect that companies with a larger proportion of coopted directors will foster an inefficient decision-making process resulting in fluctuations in cash flow and increased default risk. Further, to provide more evidence in this regard, a positive correlation has been identified between BCO and corporate risk-taking behavior, all else being equal, as observed in a study by Huang et al. (2021), Kao et al. (2020). The subsequent occurrence of BCO raises concerns about safeguarding shareholder interests, particularly when CEOs continue to hold their positions after adopting higher-risk strategies.

Moreover, the European origin banks may exhibit more financial stability along with increased independence of the board. Around 60% of directors on board may help acquire more financial stability for European banks (Brogi and Lagasio, 2022). The US firms exhibit more solvency risk as much as BCO is enhanced (Baghdadi et al., 2020; Coles et al., 2014). Further, Addo et al. (2021) explained the fact that European banks show less risk with independence of the board and independent directors up to 50% of total board may support reducing risk. Therefore, the literature clearly explains that in US and Europe, the concept of board independence is aligned with risk reduction for banks and firms whereas BCO may contribute to various risks.

There is a considerable argument in cooption-related literature that BCO may either reduce risk or do not have any significant relationship with risk. The existing body of literature provides supporting evidence that BCO is linked to reduced default risk in stressful conditions (Chaivisuttangkun and Jiraporn, 2021). This proposition is evident when the coopted board directors allow managers to enhance personal emoluments and not take any unnecessary steps or risks (Cassell et al., 2018; Coles et al., 2014; Huang et al., 2019; Jiraporn and Lee, 2018b). Consequently, entrenched managers may lean towards a risk-averse approach, often characterized as a “quiet life,” where no unnecessary risks are taken by managers under advice to coopted boards (Bertrand and Mullainathan, 2003; Cohen et al., 2013). The firm’s performance does not improve or decline due to the quiet life phenomenon that triggers high default risk. This indicates that co-opted directors do not (influence the managers to) take any risks, being “quite life” so we may not be able to observe any significant relation between solvency risk and BCO, which is also the first hypothesis proposed by our research, keeping in view our sample of Australian and New Zealand banks. Moreover, coopted boards may, in agreement with “quiet life,” ask managers not to take the risk of leveraging up the business operations or finances and to keep the firm matters status quo to prolong their careers, which also indicates no significant risk issues. Therefore, higher degree of BCO indicates superior power of the CEO in the decision-making process (Huang et al., 2021) which may subsequently affect solvency risk.

In light of the preceding discussion, it is evident that corporate executives face more severe consequences compared to investors in the event of bankruptcy. Evidence indicates that CEOs after a corporate firm’s default often struggle to secure employment at lower wages due to reputation issues, resulting in a significant decrease in their lifetime earnings. Therefore, CEOs and boards may proactively avoid unnecessary risks to prevent such situations and same can be the case for banks in Australia and New Zealand. Additionally, based on our theoretical justifications and relevant theories (Agency, Financial Intermediation and Risk Transformation), we confidently hypothesize that BCO may not significantly affect bank solvency risk for banks in Australia and New Zealand. Furthermore, we assert that TBC and RCB may not significantly affect bank default risk in the same context.

Keeping in view the significance of phenomenon of BCO, it is imperative to discuss the two alternative proxies to BCO which are TBC and RCB. Tenure-weighted cooption (TBC) considers the likelihood that directors appointed by the CEO may become progressively more coopted over time, with their influence on board dynamics growing in tandem with their tenure. TBC needs calculations where we divide the tenure of coopted directors on the board with the total tenure of all the directors on the board. Resultantly, TBC depicts increasing trend of BCO. In addition, we introduce an alternative proxy known as RCB which is regression of BCO on CEO tenure (Coles et al., 2014). This residual measure is not correlated with CEO tenure. Certain potential issues can arise as BCO and TB Cooption measures positively correlate with CEO tenure. However, Residual cooption removes the positive correlation between CEO tenure and BCO. Thus, the multicollinearity issue could be resolved using Residual Cooption (Coles et al., 2014). Notably, our findings remain consistent when utilizing these multiple alternative measures of cooption.

Based on the extensive research by Baghdadi et al. (2020) and Bharath and Shumway (2008), we have incorporated controls for key factors directly influencing solvency risk. These factors include the natural logarithm of equity (Ln Equity), the natural logarithm of total assets (Ln Gross Total Assets) and the ratio of net income to the average total asset (ROAA). Consistent with existing literature, for example Coles et al. (2014), Huang et al. (2021), Jiraporn and Lee (2018b), we have also included the proportion of female directors serving on the board of directors (Female), CEO tenure, Return on Average Equity (ROAE), Loan Loss Reserve (LLR) and Non-Performing Loans (NPL) ratio as controls, considering their significant importance in assessing bank solvency risk (Almarzoqi et al., 2015). Additionally, the macroeconomic variable of GDP growth has been included as a control in our regression equation (Jiraporn and Lee, 2018a, b; Lee et al., 2021a, b; Zheng et al., 2019). Our comprehensive literature review provides a solid foundation for hypothesis development and a robust regression model, contributing uniquely and timely to understanding BCO and bank solvency risk.

The financial data of New Zealand and Australian banks is extracted from their annual reports, Bankfocus and world economic indicators (World Bank). The board data has been extracted from audited annual reports and the board database of the selected banks. The data duration is 11 years, from 2011 to 2021. Eight banks from New Zealand and 20 banks from Australia were selected for our research, as presented in Table 1.

Table 2 presents the variables, definition and data collection sources used thereof. The independent variable BCO means those directors that were selected after the new CEO joins the office. The measure of this variable value reaches between 0 and 1, and values closer to 1 show higher cooption (Coles et al., 2014).

We also employ an alternative gauge of cooption, referred to as Tenure Weighted Cooption (TBC). This distinctive measure considers the progressive augmentation of influence exerted by coopted directors on board deliberations as they collaborate with the CEO and previously appointed directors. This metric operates on the assumption that corporate board decisions are more influenced by cooption if tenure of such coopted directors is longer on board. Measuring value span between 0 and 1 is same as for cooption measure as outlined by Coles et al. (2014).

Here, the variable Coopted Director Dummy (denoted as i) assumes a value of one at a point where director “k” is classified as a coopted director, and value of zero when director is not coopted. Meanwhile, Tenure k signifies the duration of director “k” tenure on the board. Another measure of cooption is RCB already discussed. The literature has also introduced further control variables regarding BCO and bank solvency risk. Various studies have used BCO controls described in Table 2.

The proxy used for measuring dependent variable of Solvency Risk is “Z-score” which is a representation of the degree of standard deviations by which the return on average asset has to be decreased to achieve a negative return (loss). The higher value of z-score represents lower probability of default risk. Z-Score is utilized many landmark studies related to bank risk management empirically like Baghdadi et al. (2020), Beck et al. (2013), Boyd and De Nicolo (2005), Čihák and Hesse (2010). Z-score is a better measure of stability especially for cross-country comparisons. Čihák and Hesse (2010) mentioned that Z-score is frequently utilized for measurement of banks’ insolvency risk. The formula for this proxy is as follows:

where the return on average asset is represented by ROAA, the ratio of equity to assets is CAR and σ (ROAA) is the standard deviation of ROAA (Zheng et al., 2019).

Table 3 presents descriptive statistics of our data. We observe that the mean values of BCO and TBC are 0.152 and 0.355, respectively. All other independent, dependent and control variables’ descriptive stats are mentioned in this table. In  Appendix, Table A1 exhibits Pearson correlation coefficients for all the dependent and independent variables. The solvency risk is estimated through z-score. We can observe a significant correlation between board-cooption and z-score along with GDP growth, coopted independence and NPL. The variable correlations, on average, aren’t on the higher side, showing lower chances of any multicollinearity. The correlations presented in the table provide a generalized idea of the bivariate relations among variables other factors are not rigorously controlled by them. Thus, regression analysis is deployed as a robust estimation technique.

First, we discuss the operationalization of our regression Model. Considering the heterogeneity of panel data entities, fixed-effects and random-effects models have been deployed for our regression estimations. Panel data econometric tests guide us regarding these models. The Hausman Test was used to decide whether Random or fixed-effect regression models fit our analysis. The fixed-effects regression methodology effectively captures temporal variations within firms, thereby mitigating the potential for omitted-variable bias (Coles et al., 2014). Entity-wise or within-bank correlation of errors has been treated through robust standard errors clustered at the bank level.

Proposed model (1) will assess BCO’s role on the solvency risk (Z-Score). Board Cooption here is the BCO, whereas Xit, Wit and Zit are bank-specific, board-specific and country-specific control variables. “α” is the constant or intercept, and “μ” is the error term. “i” represents the entities or banks and “t” represents time period. Similarly, for other three proxies of BCO Coles et al. (2014), we have Model 2 and Model 3 as elaborated above.

Table 4 present the regression results of relationship among BCO and solvency risk as per equation elaborate (1a) below in detail:

The results of both fixed and random-effects models are presented in Table 4. The regression results in Table 4 show that the statistical relationship between Cooption and z-score is negative and highly significant for both fixed-effects and random-effects models. This implies that the risk of solvency measured through Z-score is directly related to increased coopted board directors. A unit increase in cooption increases default risk by 1.473 units for fixed-effects model and 1.012 units for random-effects model. These results for Australia and New Zealand banking sector corroborate with findings of Brogi and Lagasio (2022), Coles et al. (2014), Baghdadi et al. (2020) and Addo et al. (2021) which exhibit the same scenario for United States and European banking sector, where cooption enhance risk for banks and firms. It also shows the generalizability and applicability of our econometric model. Further it adds to applicability of theory of cooption to various geographic location like Australia and New Zealand around the globe.

Therefore, we observed that cooption increases default risk in both New Zealand and Australian banks and CEO tenure is vital and longer tenure CEOs have dominating influence on boards decisions owing to TBC. Keeping in view positive and significant relation of TBC and default risk, banks in Australia and New Zealand must monitor board governance of banks carefully and our findings in this regard are of vital nature.

The probability F-stat indicates the strength of our model, whereas the Hausman test value shows the suitability of the fixed-effect regression model. Our results are in line with findings of Baghdadi et al. (2020), Coles et al. (2014). Therefore, our null hypothesis is not accepted. We can safely conclude that cooption increases default risk in the studied banks, which is a new insight and a timely contribution to the literature.

We further observe that controls of total assets, GDP growth, LLR and NPL have significant and negative coefficients of Z-score, thereby showing a direct relation with default risk. As much as banks’ assets grow, keeping in view the BCO, the default risk grows. Similar is the case for NPL, LLRs and GDP whereas return on equity is indirectly related to default risk. Moreover, RoRWA, net profit and equity has positive regression coefficients showing a significant and indirect relation with default risk. This shows that the return on risk-weighted assets decreases as much as default risk increases and vice versa in Australian and New Zealand banks. In contrast, Baghdadi et al. (2020) explored the direct relationship between cooption and default risk in US firms. Our results remain unchanged for random-effects regression model as well eliminating the endogeneity bias.

As detailed in equation (2a), Table 5 presents the outcomes of the regression analysis investigating the link between tenure weighted BCO and solvency risk.

The TBC measure of BCO has been regressed on default risk as per model 2, with results in Table 5. Both fixed-effects and random-effects regression models show a negative and highly significant relationship between TBC and z-score, indicating that default risk increases with more coopted directors on boards. This implies that CEO tenure is vital, as longer-tenure CEOs dominate board decisions owing to TBC. A unit increase in TBC increases default risk by 0.53 units for the fixed-effects model and by 0.40 units for the random-effects model. Baghdadi et al. (2020) and Coles et al. (2014) have observed the same in their respective studies. The underlying hypothesis of no significant relationship between tenure-weighted BCO and default risk is not accepted similarly to our Model 1. Therefore, banks in Australia and New Zealand must carefully monitor board governance due to the positive and significant relationship of TBC and default risk.

Our utilization of the third cooption measure involves RCB, a concept originally introduced by Coles et al. (2014). This measure is derived from regression of cooption on CEO tenure and the residual value resulting from this regression is considered RCB measure value. We have subsequently subjected it to regression analysis within the framework of our Model 3, examining its correlation with default risk. The detailed outcomes of this analysis are presented in Table 6. RCB removes correlation between CEO tenure and BC. The results are same as our previous Regression Models 1 and 2.

Therefore, we observed that cooption increases default risk in both New Zealand and Australian banks and CEO tenure is vital and longer tenure CEOs have dominating influence on boards decisions owing to TBC. Keeping in view the positive and significant relation of TBC and default risk, banks in Australia and New Zealand must monitor board governance of banks carefully and our findings in this regard are of vital nature.

Table 6 reports the regression findings that examine the relationship between residual BCO and solvency risk, as specified in detail by equation (3a):

A GMM regression model was also deployed for robustness. The results were similar to our main regression model and supported our findings. Endogeneity concerns may persist in our model despite using fixed-effects and instrumental regression. To address this, we adopted the Generalized Method of Moments (GMM) to capture the dynamic nature of our panel data. The system GMM exhibited superior properties compared to the “Difference GMM” (Arellano and Bond, 1991) this method was further refined (Blundell and Bond, 1998) followed by Arellano and Bover (1995).

The results corroborated our earlier findings, reflecting the robustness of our model for testing the relation between BCO and solvency risk. The diagnostic statistics of AR₍₁₎ and AR₍₂₎ regarding autocorrelation in differenced residuals supported the suitability of system GMM for our model, strengthening our regression results in Table 7.

So, following are our findings and practical implications which will be of great benefit to policymakers, Government, bankers, financial services industry experts, researchers and academicians, (1) The BCO is a phenomenon of significant importance prevailing in Australian and New Zealand banks and it enhances bank default risk as explored in our study and previously by Baghdadi et al. (2020) and Coles et al. (2014) for US firms. Further, the same results are reiterated in context of European banks which emphasize the usefulness of independence of boards contributing to risk reduction (Addo et al., 2021; Brogi and Lagasio, 2022). (2) The default risk is considered to be one of the most important risks for banks under Basel agreements as mentioned by Almarzoqi et al. (2015). Therefore, the influence of cooption must be treated on the bank’s governance boards through strategic policymaking in Australia and New Zealand. The instances of misconduct in these countries banking sector may be reduced by efficient board governance and controlling the phenomena of BCO (3) Bank defaults triggered by BCO can seriously affect these two countries’ economies and financial conditions. (4) The phenomenon of BCO hadn’t been studied in Australian and New Zealand banks before like it has been researched in USA and European banks where results show the significance of BCO to manage banks risks. Therefore, our study initiates new insight regarding cooption prevailing in the banking industry of these two countries. The “excessive risk-taking or quiet life” behavior of managers can be identified by observing board-cooption phenomenon in banking industry of New Zealand as cooption and solvency risk relationship is significant for both countries banking industry. Further, BASEL-III requirements of developing exhaustive risk management framework and efficient corporate governance can be achieved by studying this very relationship. (5) The corporate governance boards of banks must devise policies for appropriate board compositions where the director’s impartiality and independence are visible. (6) Investors (shareholders) and banking industry stakeholders must emphasize the importance of board governance. (7) The shareholder’s investments in banks’ shares must be subject to vigilance regarding transparency of board governance, minimizing agency conflict and smoothing the process of risk transformation, and financial intermediation. The government and regulators in Australia and New Zealand must monitor corporate board governance in banks as cooption has been established in banks in both these countries. (8) The BCO theory has been studied regarding US firms and European banks etc.; however, now these two countries’ regulators/finance ministries must establish board-cooption-related policies and prudential regulations. (9) Academic researchers may get significant guidance from our study regarding exploring the phenomenon of BCO. (10) For efficient risk management and transparent board governance, the Government, research institutions and banks should grant special research funding to highlight strategic issues related to board-cooption and default risk.

The role of board governance is crucial and significant for risk management in banks. The phenomenon of BCO has challenging impact on bank risk management which is an undiscovered area. Our study strives to fill in the gap as to how board composition impacts the default risk in banks in Australia and New Zealand. This study provides insights into the relationship between board-cooption and default risk in Australian and New Zealand banks which was discussed for US and European banks and firms in earlier researches (Addo et al., 2021; Baghdadi et al., 2020; Brogi and Lagasio, 2022; Coles et al., 2014). The impartiality and independent decision-making on behalf of the corporate board have been tested through cooption measures, which depict a noteworthy and statistically significant positive correlation with solvency risk. These findings remain consistent and rigorous to robustness tests and concerns related to endogeneity. To solidify our findings, we also used alternate proxy measures of coopted non-independence and non-coopted directors, and our results were consistent. Further analyses indicate that the direct relationship between cooption and solvency risk can deteriorate independent decision-making quality and hinder transparency in the strategic decision-making process. These factors contribute to performance fluctuations and inconsistent decisions on behalf of the board.

In summary, our research stands as the pioneering effort to explain the significant adverse impact of cooption on corporate decision-making and management within the banking sectors of Australia and New Zealand. These Banks must carefully establish a risk management framework under the Basel Accords to avoid risks like default risk. The regulators in the financial services industry may also devise mechanisms and regulate the banks under the second pillar of Basel-II and III, “Supervisory Review Process.” This research study presents new evidence that co-opted boards contribute to corporate solvency or default risk, and future researchers can address some other significantly important topics, such as the relationship of credit or liquidity risk with BCO in different geographical locations.

Our study offers new insights and adds to the existing body of knowledge. Due to the limited availability of similar studies, it can be used as a reference point for future researchers. Additionally, researchers can expand risk analysis to include market risk and ESG (Environmental, Social and Governance) risk and explore banking industry trends in other global regions such as Europe, China and Southeast Asia.