Purpose: The study purport to investigate the effectiveness of internal control mechanisms,
investigate whether evidence of agency problem is found among banks in Europe and
determine how internal controls affect credit risk.
Design/methodology: Panel data from 91 banks from 23 European Union countries were
studied from 2008-2014. Hausman’s specification test suggest the use of fixed effects
estimation technique of GLS. Quantitatively modelled data on 15 variables covering elements
of internal controls, objectives of internal controls, agency problem, bank and country specific
variables were used.
Findings: There is still high credit risk in spite of measures being implemented by the
European Central Bank. Banks have individual entity factors that increase or decrease credit
risk. The study finds effective internal control systems because objectives of internal controls
are achieved and significantly determine credit risk. Agency problem is confirmed due to
significant positive relation with credit risk. There is significant effect of internal controls on
credit risk with specific variables as risk assessment, return on average risk weighted assets,
institutional ownership, bank size, inflation, interest rate and GDP.
Research limitations/implications: Missing data prevented the use of strongly balanced
panel. The lack of flexibility with using quantitative approach did not allow further scrutiny of
the nature of variables. However, statistical tests were acceptable for the model used. The study
has implications for management and owners of banks to be warry of agency problem because
that provides incentive for reckless high risk transactions that may benefit the agent than the
principal. Management must engage in actions that profile the company better and enhances
value maximization. Rising default risk has tendency to impair corporate image leading to loss
of reputational capital.
Originality/value: The study provides the use of quantitative approach to measuring certain
phenomena within the discipline of internal controls. The study adds to a previous study by
same authors and confirming the agency problem in a different approach.
