Corporate governance in the U.S. banking industry has become an increasingly important influence on banks’ ratings and outlooks in recent years, a new research report by Moody’s Investors Service Inc. concludes.

The firm says corporate governance has become an increasingly significant rating factor principally as a result of control failures at the banks.

‘In some cases, control failures have had a significant effect on the rating or outlook — either leading to downward movements or creating constraints on future uplifts,” says Mark Watson, Moody’s senior vice president and an author of the report.

“Conversely, improved corporate governance in certain companies — either initiated internally by the bank or initiated by regulatory action — led to positive rating actions,” he notes. “At least, sometimes, these resulted in Moody’s sustaining current rating levels in the expectation that corporate governance would improve.” Governance practices contributed to Wells Fargo Bank N.A.’s upgrade in 2003, as well as, the change in Sovereign Bancorp’s outlook to positive from stable in 2005.

“In all cases,” Watson adds, “failures of corporate governance in U.S. banks have led to rating committee discussions — often with a focus on short-term financial impacts, like fines or litigation costs, and the potential for long-term consequences, such as damage to the bank’s reputation or its relations with regulators.”

The rating agency, which reviews 27 major U.S. banks, says it has been encouraged that more vigorous regulation has helped to bolster corporate governance, resulting in intensified board review of key exposures, more creditor-friendly compensation practices, and more formal succession planning and performance evaluations.

Watson cautions, however, that the relatively strong banking regulatory environment does not preclude governance challenges. For instance, he notes, control failures continue to occur, and internal audits may have failed in some banks. And the average bank board’s composition is far from optimal, Moody’s says. It found that many bank boards are too large, averaging 15 members, compared with an average of 11 for other U.S. companies.

“Also, mergers create oversight challenges because they load new organizational and operational complexities on board members at a time when they are already under increased pressure to be more diligent in their roles,” Watson adds. “Finally, risk oversight provides a distinct challenge to bank boards, particularly in light of Basel II.”