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Corporate goverance


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Corporate goverance

  1. 1. THE CORPORATE GOVERNANCE OF BANK Chapter 1 INTRODUCTION The Corporate Governance of Banks The dominant model of corporate governance in law and economics is that the corporation is a “complex set of explicit and implicit contracts.” In other words, one shoud view the corporation as nothing more (or less) than a set of contractual arrangements among the various claimants to the product and earnings generated by the business. Every business organization, including the corporation, “represent nothing more than a particular ‘standard form’ contract. “ The very justification for having different type of business organizations is to permit investors, entrepreneurs, and other participants in the corporate enterprise to select the organization design they prefer from a menu of standard-form contracts. The virtue of the standard-form arrangement characteristic of modem corporate enterprise to take advantage of an arrangement that suits the needs of investors and entrepreneurs in a wide variety of situations. Every business organization, including the corporation,”represents nothing more than a particular ‘standerd form’ contract.” The very justification for having different type of business organization is to permit investors, entrepreneus, and other participant in the corporate enterise to select the organization design they prefer from a menu of standard-form contracts. The virtue of the standard-form arrangement charactreristic of modern corporate law is that it reduces transaction costs by allowing the participants in the corporate enterprise to take advantage of an arrangement that suits the needs of investors and entreprerneurs in a wide variety of situations. On a theoretical level, the problems of corporate governance result from the existence of incomplete contracts. The rules of corporate governance are K.G. MITTAL COLLEGE OF COMMERCE 1
  2. 2. THE CORPORATE GOVERNANCE OF BANK aimed at resolving the gaps left in these contracts in ways consistent with maximizing the value of the firm. In the case of shareholders contingent contracts in the United States, these background rules are called fiduciary duties. The economic justification for having fiduciary duties is straightforward: “Fiduciary duties are the mechanism invented by the legal system for filling in the unspecified terms of shareholders contingent [contracts]. The presence of fiduciary duties attempts to address these contingencies. In this gap-filling role, fiduciary duties essentially call on directors to work hard and to promote the interests of shareholders above their own. The duty of care requires that directors exercise reasonable care, prudence, and diligence in the management of the corporation. Director liability for a breach of the duty of care may arise in two discrete contexts. First, liability may flow from “ill advised or negligent” decision –making. Second, liability may be the result of failure of the board to monitor in “circumstances in which due attention would, arguably, have prevented the loss.” ‘Significantly, in both classes of cases, directors are entitled to rely on information, reports, statement, and opinions prepared by the company’s officers and directors as well as outside consultants. Separation of Ownership and Control The problem of corporate governance is rooted in the Berle-Means (1932) paradigm of the separation of shareholders ‘ownership and management’s control in the modern corporation. Agency problems occur when the principal (shareholders) lacks the necessary power or information to monitor and control the agent (managers) and when the compensation of the principal and the agent is not aligned. Several factors work to reduce these principal-agency costs, The “market for managers “ penalizes management teams that try to advance their own interest at shareholders’ expense. On possible solution to the agency cost problem is to give shareholders direct control over management. This is the case when management and shareholders are the same party and control right automatically rest in the hands of shareholders. K.G. MITTAL COLLEGE OF COMMERCE 2
  3. 3. THE CORPORATE GOVERNANCE OF BANK Although these are potentially powerful concerns about the effectiveness of shareholder control, recent research suggests that the more fundamental trade- offs may guide the desired involvement of shareholders in corporate control. Burkhart Gromb, and Panunzi (1997), for example shows that direct shareholder control may discourage new initiatives on the part of managers. These observations are consistent with real-world corporate governance arrangements, which almost without exception limit direct shareholder involvement. In some cases –particularly in the United State-this it facilitate by relatively dispersed ownership. Banks are organized in a variety of ways, from stand-alone corporate entities and single bank holding companies to multiple bank holding companies and the post-Gramm- Leach –Bliley Act (GLBA) diversified holding company. This diversified structure permits such holding companies to reduce or eliminate the firm- specific risks associated with the banks they own. The GLBA significantly enhanced this diversification ability by permitting bank holding companies and certain other restricted firms to become a new entity: a financial holding company (FHC) This dispersion of activity throughout the holding company structure also gives incentives to bank holding companies to put more risky behavior in their federally insured banks.. Special Problems of Banks The discussion so far has focused on a general overview of corporate governance. We now know turn to specific problems of banks and attempt to address why the scope of the duties and obligations of corporate officers and directors should be expanded in the case of banks. Our argument is that the special corporate governance problems of banks weaken the case for making shareholders the exclusive beneficiaries of fiduciary duties. Our focus here is K.G. MITTAL COLLEGE OF COMMERCE 3
  4. 4. THE CORPORATE GOVERNANCE OF BANK on establishing why banks are not like other firms and thus should be treated differently. The Liquidity Production Role of Banks Many different types of firms extend credit . Similarly, a variety of non-bank firms most notably money market mutual funds and non-bank credit card companies, offer the equivalent of a check transaction account. What distinguished banks from other firms is their capital structure , which is unique in to ways.First, banks tend to have very little equity relative to other firms. Second, banks, liabilities are largely in the from of deposits, which are available to their creditors /depositors on demand, while their assets often take the from of loans that have longer maturities (although increasingly refined secondary market have mitigated to same extent mismatch in the term structure of banks’ assets and liabilities ). Thus, the principal attribute that makes banks banks as financial intermediaries ‘special’’ is their liquidity production function. By holding illiquid assets and issuing liquid liabilities, bank create liquidity for the economy. The liquidity production function may cause a collective-action problem among depositors because banks keep only a fraction of deposits on reserve at any one time. Depositors because banks keep only a fraction of deposits on reserve at any one time. Depositors cannot obtain repayment of their deposits simultaneously because the bank will not have sufficient funds on hand to satisfy all depositors at once. The Deposit Insurance Fund In the wake of the mass failure of depository institutions, Congress passed the Banking Act of 1933 establishing the Federal Deposit Insurance Corporation (FDIC) and giving the federal government the power to insure deposits in qualified banks.The creation of federal deposit insurance has been tremendously effective in preventing bank runs and keeping the failure of individual banks from affecting the larger economy. Deposit insurance “has K.G. MITTAL COLLEGE OF COMMERCE 4
  5. 5. THE CORPORATE GOVERNANCE OF BANK succeeded in achieving what had been a majer objective of banking reform for at least a century, namely the prevention of banking panice.” Deposite the positive effect of FDIC insurance on preventing bank runs, the implementation of deposit insurance poses a regulatory cost of its own-it gives the shareholder and manager of insured banks incentives to engage in excessive risk-taking. The problem of moral hazard is exacerbated in situations where a bank is at of near insolvency. In such a situation, the shareholders have a strong incentive to increase risk because they can allocate their losses to third-parties while still receiving any gains that might result from the risky behavior. The Conflict Fixed Claimants and Shareholders A conflict between the interests of debt holders and the interests of shareholders exists in every firm. Among any particular set of asset allocation decisions, any investment strategy that increases risk will transfer wealth from the fixed claimants to the residual claimants. This problem is raised to a new dimension in the banking context because of the high debt-to-equity ratio and the existence of deposit insurance. In the publicly held corporation, the problem of excessive risk-taking is mitigated by two factors. First, various devices serve to protect fixed claimants against excessive risk-taking. Corporate lenders typically insist on protection against is reduced to some extent because managers that threaten their fixed claims. Second , risk-taking is reduced to some extent because managers are not perfect agents of risk-preferring shareholders. Managers are fixed claimants to that portion of their compensation designated as salary. In addition, managerial incentives for risk-taking are reduced, since managers have invested their non- 0diversifiable human capital in their jobs. This capital would depreciate significantly in value if their firms were to fail The adverts incentive for risk-taking caused by federal insurance is one reason to have stricter accountability requirements for directors of blanks. K.G. MITTAL COLLEGE OF COMMERCE 5
  6. 6. THE CORPORATE GOVERNANCE OF BANK Asset Structure and Loyalty Problems The presence of federal insurance fund also increased the risk of fraud and self-dealing in the banking industry by reducing incentives for monitoring . In the 1980,it was estimated that fraud and self-dealing transaction werte”apparent “ in as many as one-third of today’s bank failures. 28 A similar statistic shows that between 12990 and 1991, insider lending contributed to 175 of 286bank failures,29 Such behavior, of course, is a possibility in any large firm, since it is inefficient for owners to monitor all employees at all times. These sorts of problems are particularly acute in financial institutions, however, because of the large portion of their asset held in highly liquid form. The same regulatory structure that creates a problems if excessive risk-taking by banks also leads to a reduction in the normal levels of monitoring within the firm, resulting in a higher incidence of bank failures due to fraud. Shareholders have an incentive to monitor to prevent fraud and self-dealing in banks, but such monitoring is notoriously ineffective in many cases because individual shareholders rarely have sufficient incentives to engage in monitoring because of collection-action problems. One might argue that FDIC insurance simply replaces one set of creditors: depositors, with another set of creditors: state and federal regulators. These other creditors might more financially sophisticated than rank-and – file depositors and thus appear in a better position to conduct the monitoring necessary to prevent bank fraud. Regulators have five main enforcement tools: cease and desist powers, removal powers, civil money penalty powers, withdrawal or suspension of federal deposit insurance power and prompt corrective actions powers. Cease and desist powers generally address both unsafe and unsound banking as well as violations of the law or regulations governing depository institutions. Federal banking agencies also have to impose civil monetary penalties against a banking institution and its affiliates. Prompt corrective-action powers are also triggered by capital requirements, and these allow regulators K.G. MITTAL COLLEGE OF COMMERCE 6
  7. 7. THE CORPORATE GOVERNANCE OF BANK to reach every significant operational aspect of a bank. Finally, the FDIC has the authority to revoke a bank’s depositor insurance if necessary, Nevertheless, replacing private- sector creditors with public-sector regulators as the first line of the first line of defence against bank fraud and self-dealing presents two problems. Private-sector creditors have stronger incentives than public-sector regulators to monitor closely for fraud and self-dealing. K.G. MITTAL COLLEGE OF COMMERCE 7
  8. 8. THE CORPORATE GOVERNANCE OF BANK Chapter 2 Is Corporate Governance Different for bank Holding Companies? Renee Adams and Hamid Mehram The governance structure in banks should aim at enhancing Accountability and efficiency. Corporate governance in Banks is different from that of manufacturing compananies Governance reforms required for banks should be industry Composition and compared to the board in Manufacturing companies. Futher research on corporate Governance in banks would determine the optimal board Size that maximizes shareholder value subject to the Constraints imposed on these firms. Why Governance May Differ for Bank Holding Companies Shleifer and Vishny define corporate governance as dealing “with the ways that suppliers of finance to corporations assure themselves of getting a return on their investment” if managers operate independently, they may make K.G. MITTAL COLLEGE OF COMMERCE 8
  9. 9. THE CORPORATE GOVERNANCE OF BANK financing, investment, and payout decisions that are detrimental to shareholders. The governance of banking firms may be different from that unregulated, non –financial firms for several reasons. For one the numbers of parties with a stake in an institution’s activity complicates the governance of financial institutions. As a result, the board of directors of a banking firm is placed in a crucial role in its governance structure. Although the board of BHCs are assigned the same legal responsibilities as other boards, regulators have placed additional expectations on bank, as opposed to BHC boards that delineate their responsibilities even further. These and other differences in the operation of financial and non-financial institutions have loed many to view regulatory oversight of the industry as a substitute for corporate governance as less critical to the conduct and operation of banking firms. ‘ Other argue that effective supervision could lead to board oversight becoming a more critical element of banking firm governance –dtha is, these could be complementary forces. Thus, although in non-financial firm stock options may be appropriate instruments to provide incentive for managers to create value, as well as to protect the creditors of distressed companies, the options may conflict with policy objectives that seek to protect the non-shareholding ,stakeholders, such as depositors and taxpayers in financial firms. Resolution of a financially distressed condition or outright in insolvency in the banking industry can also have an important effect on top manager’s incentive structures. In an unregulated environment, financial distress generally leads to reorganization and in most cases, the incumbent top manager is given the opportunity to turn the corporation around. Our banking sample consists of thirty-five publicly traded bank holding companies that were among the 200 largest top-tier BHCs in terms of book value of assets for each year between 1986 and 1996. We collected additional data on these firms for 1997-99; however, the number of firms dropped to thirty-two during those years due to merger and acquisition activity. For 1997,1998 and 1999, our sample consists of thirty-four, thirty- K.G. MITTAL COLLEGE OF COMMERCE 9
  10. 10. THE CORPORATE GOVERNANCE OF BANK three, and thirty-two institutions, respectively. The requirement that the firm be publicly traded makes it possible to collect data on internal governance characteristics from proxy statements filed with the Securities and Exchange Commission. However, the requirement was imposed to study the role of governance in firms where the potential impact of poor governance could be serious. The assets of our sample of BHCs constitute a large fraction of total Industry assets (32.30 percent of all top-tier BHC assets in 1990). Findings from the Corporate Governance Variables We emphasize that our analysis and comparison are not regression-based; rather, our purpose is to compile a series of descriptive statistics in one place. We choose manufacturing firms for comparison because their governance structures have been analyzed more extensively by researchers than those of firms in other industries; data availability was also a determining factor. Board Size and Composition An average of eighteen directors make up each BHC board, although there is a wide distribution of board size in the sample (a minimum of eight directors and a maximum of thirty-six). Over the sample period, it is apparent that banking firm boards are becoming smaller. An average board in1999had 17 directors (median: 18), down from 20.3 in 1986 (median: 20). The trend is consistent with the finding of Adams and Mehran (2002), who examine BHC board size over the 1959-99 period. As Table 3 indicates, an average S&P manufacturing firm had six fewer directors than an average BHC did over the sample period. Booth, Cornett, and Tehranian (2002)also provide evidence that banks have larger boards, using a sample of the 100 largest BHCs and the 10-0 largest manufacturing firms in 1999. Since such regulatory restriction generally apply to board structure at the bank level and not the holding level, which is the focus of this study, the regulatory environment alone does not explain BHC board size and composition However, regulation may have an indirect on the structure of BHD board to the extent that it is influenced by the structure of the board of the BHC’S lead bank and other subsidiary banks K.G. MITTAL COLLEGE OF COMMERCE 10
  11. 11. THE CORPORATE GOVERNANCE OF BANK Board Activity The number of annul board meeting for a bank, rather than a holding company, is regulated at the state level. For example, during our sample period, New York state member banks were required to have a minimum of ten meetings per year. State regulations on the number of meetings may influence the bank’s choice of directors, since potential directors might have a better change of being nominated if they live within proximity to the bank24 CEO Compensation The increased use of stock option in executive compensation packages in banking follows the pattern of other industries even though the growth and level of stock option use are significantly lower than in manufacturing firms. One potential explanation for the lower reliance on stock option in the banking industry found in smith and watts (1992), who show that-growth industries rely less on stock-based compensation (also see Mehram [1992]). Smith and Watts suggest that board can observe, monitor,and evaluate the action of CEOs of firms and industries with low-growth opportunities much easier than they can in firms or industries with high-growth opportunities. Thus, board in such industries should rely more on fixed rather than on stock- based compensation. Based on several proxies for growth opportunities advanced in the literaturesuch as Tobin’s Q, market-to-book ratio, research-and-development- to –sale ratio, and volatility-BHCs can be considered to have the characteristics of low-growth firms. Finally, given the low stock-return volatility in the banking industry, all else equal, the value of stock option in banks will be lower. To compensate the K.G. MITTAL COLLEGE OF COMMERCE 11
  12. 12. THE CORPORATE GOVERNANCE OF BANK CEO for a given dollar value of granted options, the has to give a larger number of option relative to those given by an average manufacturing firm . CEO Ownership CEO ownership across BHCs and manufacturing firms may differ for several reasons. One can argue that the samaller flow of options to bank holding company CEOs leads to smaller ownership (We do not report the number of options granted to CEOs).25 There may also be are a machanicial issue influencing the percentage of ownership.Since BHCs are significantly more leveraged and have more assets than manufacturing firm, ownership levels across the two types of firms may not be compararable.29 An important insight of Modigliani and in a word with corporate taxes is that the case flow claims of an ownership stake in an all-equity firm differ from those associated with the percentage of equity ownership of an identical firm with a positive debt level. Block Ownership To compile our statistics on block ownership, we rely on the CDA/Spectrum Institutional Holding Database of Thomson Financikal. Institutional shareholding is our proxy for monitotring by blockholders. However, the corporate governance literature also emphasizes the importance of the identity of the identity of blockholders and individuals, as opposed to just the size of institution holdings. Bank-affiliated institution are unlikely to moniter the BHC over the course of these activities; therefore, to construct our summary statistics on institution holders, we deledted all bank-affiliated institution from the list of institution holders of our BHCs in all year.We also examined the identity of institutional holding shares of manufacturing firms; however, found very few cases of blockholders that were affiliated with manufacturing firms K.G. MITTAL COLLEGE OF COMMERCE 12
  13. 13. THE CORPORATE GOVERNANCE OF BANK Chapter 3 Basel II and Role of Pillar 2: Ensuring High Standards of Corporate Governance A.The Basel Committee The Basel Committee on Banking Supervision is a committee, of banking supervisory authorities, established by the Central Bank Governors of the G10 developed countries in 1975. The committee in 1988 introduced the concept of capital Adequacy Framework, Known as Basel Capital Accord, with a minimum capital adequacy of 8 percent. This accord has been gradually adopted not only in member countries but also in more one hundred other countries, including India. B. Basel II: The New Basel Capital Accord The committee issued a consultative document titled “The New Basel Capital Accord” in April2003, to replace the 1988 Accord, Which re-enforce the need for capital adequacy requirements under the current conditions. This accord is commonly known as Basel II and is currently under finalization. Basel II will be applied on a consolidates basis to internationally active banks. However, supervisors are required to test that individual banks are adequately capitalized on a stand – alone basis also. Basel II is based on three Pillars. • Pillar 1 – Minimum Capital Requirements. • Pillar 2 – Supervisory Review Process. K.G. MITTAL COLLEGE OF COMMERCE 13
  14. 14. THE CORPORATE GOVERNANCE OF BANK • Pillar 3 – Market Discipline. Pillar 1 discusses the calculation of the total minimum capital requirements for credit, market and operational risks and maintains the level of minimum capital adequacy at 8 percent. Pillar 2discussed the key principles of supervisory review, risk management guidance and supervisory transparency and accountability with respect to banking risks. Pillar 3 complements Pillar 1 and 2 by encouraging market discipline through enhanced disclosures by banks to enable market participants asses the capital adequacy of banks. D. Enhancing Corporate Governance in Banks The Basel committee had issued, in August 1999, a guidance paper entitled “Enhancing Corporate Governance for Banking Organizations” to supervisory authorities Worldwide to assist them in promoting the adoption of sound corporate governance practices by banks in their countries. The key features of this guidance are discussed here. I. Importance of Corporate Governance for Banks Banks are a critical component of any economy. They provide financing for commercial enterprises, basic financial services to a broad segment of the population and access to payments systems. From a banking industry perspective, corporate governance involves the manner in which their boards of directors and senior managements govern the business and affairs of individual banks, affecting how banks. • Set their corporate objective; • Run day-to-day operations; • Consider the interests of various stakeholders; • Align corporate actives with the expectation that bank will operate in a safe and sound manner and in compliance with applicable law and regulations; and • Protect the interest of depositors. K.G. MITTAL COLLEGE OF COMMERCE 14
  15. 15. THE CORPORATE GOVERNANCE OF BANK II. Sound Corporate Governance Practices for Banks The Practices mentioned below are critical to any corporate governance process in banks: 1. Establishing strategic objectives and a set of corporate values communicated throughout the organization. 2. Strong risk management functions independent of business lines, internal control systems, internal and external audit functions and other cheeks and balance. 3. Special monitoring of risk exposures where conflicts of interests are likely to be particularly great, including business relationships with borrowers affiliated with the banks. 4. Setting and enforcing clear lines of responsibility and accountability. 5. Ensuring that banks’ board members are qualified for their positions, have a clear understanding of their role in corporate governance and are not subject to under influence. 6. Ensuring that there is appropriate oversight by senior management. 7. Ensuring that compensation systems are consistent with the banks, objectives and control environment. 8. Conducting corporate governance transparently . 9. Flow of appropriate information internally and to the public. K.G. MITTAL COLLEGE OF COMMERCE 15
  16. 16. THE CORPORATE GOVERNANCE OF BANK III. The Role of Supervisory Authorities in Ensuring Effective Corporate Governance in Banks Supervisors should be aware of the importance of corporate governance and its impact on corporate performance. Supervisors should be attentive to any warning signs of deterioration in the management of the banks activities. They should consider issuing guidance to banks on sound corporate governance and the proactive practices that need to be in place. F. Corporate Governance for the Internal Ratings- based (IRB) Approach to Credit Risk as per Pert 2 Pillar 1 I. IRB Approach [Internal Rating –based ] Internal risk ratings are an important tool in monitoring credit risk. Internal risk ratings should be adequate to support the identification and measurement of risk from all credit risk and capital adequace Subject to certain minimum condition and disclosure requirements, banks that qualify for the IRB approach may rely on their own internal extimatest of risk componets include measures of the probability of Default (PD) Loss Give defatult (LGD) the Exposure at Default (EAD) and effective maturiys. I. Corporate Governance All material aspects of the rating and estimation process must be approved by the bank’s board or a designated committee thereof and senior management . Management must also ensure, on an ongoing basis, that the rating system is operating properly. K.G. MITTAL COLLEGE OF COMMERCE 16
  17. 17. THE CORPORATE GOVERNANCE OF BANK Bank must have independent credit risk control units responsible for the design, implementation and performance of their internal rating system. They must concentrate upon: • Testing and monitoring internal grades; • Production and analysis of summary report from the bank’s rating system, to include historical default data, grade migration analyses and monitoring of trends in key criteria; • Implementing procedures to verify that rating definition are consistently applied across departments and geographic areas; • Reviewing and documenting any change to the rating process; and • Reviewing the rating criteria to evaluate if they remain predictive of risks. Internal audit must review at least annually the bank’ s rating system and its operation, Good governance can be built based on the business practices adopted by the board of directors and management. Many bank failures in the past have been attributed to inadequate and inefficient management which enabled beyond the level appropriate for the banks’ capacity. Some of the key elements that Part 3 of Basel ll deals with theimportance of supervisory review,its key priniciples, specific issues to be addressed under the supervisory review process and supervisory transparency and accountability itself in ensuring effective corporate governance. A discussin follws. The supervisory review process of Basel ll is intented not only to ensure that banks have adequate capitel to support all the risk in their business, but also to encourage banks to develop and use better risk This interaction is interaction is intended to foster an active dilalogue between banks and supervisors such that when deficiencies are identified, prompt and decisive action can be taken to reduce risk or restire capitial The five main features of such a rigorous process are as follws: K.G. MITTAL COLLEGE OF COMMERCE 17
  18. 18. THE CORPORATE GOVERNANCE OF BANK A sound risk management process is foundation for an effective assessment of the adequacy of a bank’s capitel position. The analysis of bank’s current and future capital requirements in relation to strategic objectives is a vital elemente of the strategic planning process. The bank’s bord should ensure that management establishes a framework for assessing the various risk, to the bank,s capital and monitoting compliance with internal policies. It should support strong internal contrls and written polies and ensure that are effectively communicated throughout the bank. 2. sound capital Assessment fundamental principles of sound capital assessment include: . policies and procedures designed to ensure that the bank identifies, measures and reports all material risk; . a process that relates level of the capital and states capiral adequacy goals with respect to risk taking account of bank’s strategic business plen; and . a process of internal controls, reviews and adit to ensure the integrity of the overall management process. 3. comprehensive Assessment of Risk All material risks faced by banks should be addressed in the capital assessment process. While not all risk can measured precisely , an adequate and complete model should be developed estimate the various risk, such as, credit risk, operational risk, interest rate risk, liquidity risk and other risk like reputation and strategic risk. 4. monitoring and Reporting K.G. MITTAL COLLEGE OF COMMERCE 18
  19. 19. THE CORPORATE GOVERNANCE OF BANK (The bank should establish an adequate system for monitoring and reporting risk exposures in order to:) • Evaluate the level and trends of material risks and their affect on capital levels; • Evaluate the reasonableness of key assumptions used in the capital assessment measurement system; • Determine that the bank hold sufficient capital against the various risk in compliance with established capital adequacy goals; and • Assess their future capital requirement based on the risk profile and make necessary adjustments to the strategicplan Internal Contral Review The banks should regular review the following aspects of their system of internal control to ensure well-ordered conduct of business: • appropriateness of the capital assessment process; • identification of large exposures and risk concentrations; • accuracy and complecteness of data inputs into the assessment process; • validity of scenarios used in the assessment process; and • stress testing and analysis of assumptions and inputs the supervisory authorities should regularly review the process by which banks assets review of work done by external auditors and periodic reporting.five main features of this review are. 1. Review of Adequacy of Risk Assessment Supervisors should assess the degree to which internal targets and processes incorporate all material risks faced by the banks. Supervisors should also review the adequacy of risk measures used in assessing internal capital adequacy and the extent to which these risk measures are used operationally in setting limits.supervisors should consider the results of sensitivity analyses K.G. MITTAL COLLEGE OF COMMERCE 19
  20. 20. THE CORPORATE GOVERNANCE OF BANK and stress tests conducted by the banks and how these results relate to capital plans. 2. Assessment Of Capital Adequacy Supervisors should review the banks processes to determine that the target levels of capital chosen are comprehensive and relevant to the current operation environment,are properly monitored by senior management ,the copositon of capital is appropriate for the banks’ business and the extent to which the banks have provided for unexpected events in setting their capital levels. 3. Assessment of the control Environment Supervisors should consider the quality of the banks’ management information systems, the manner in which business risk and activities are aggregated and manageent’s record in responding to emerging or changing risks. They should also consider the external factors like business cycle effects and the macroeconomic environment in determining the capital levels. 4. Supervision Action Having carried out the review process described above, supervisors should take appropriate actions, sucsah as those set out under Principals 3 and 4 below, if they are not satisfied with The result of the bank’own risk assessment and capital allocation. 5. Supervision should except banks to operate with a buffer, over and above the Pillar1 capital requirement, for a number of reasons. A large number of banks prefer to be highly rated by internationally recognized rating agencies. In the normal course of business the type and volume of activities keep on changing as well as the different risk requirements causing fluctuations in the overall capital ratio. It may be costly for banks to raise additional capital during emergency need. K.G. MITTAL COLLEGE OF COMMERCE 20
  21. 21. THE CORPORATE GOVERNANCE OF BANK If it so happens, to fall below minimum regulatory capital requirements is a matter of serious concern for banks. Among other methods, the supervisors may set trigger and target capital ratios or define categories above minimum ratios for identifying the capitalization level of the banks. II. Specific Issues to be Addressed Under the Supervisory Review Process 1. Interest Rate Risk If supervisors determine that banks are not holding capital commensurate with the level of interest rate risk, they must require the banks to reduce their risk, to hold a specific additional amount of capital or a combination of the two. 2. Operational Risk The Supervisors should examine whether the capital requirement generated by the Pillar 1 calculation gives a consistent picture of the individual bank’s operational risk exposure, for example, in comparison with other banks of similar size and operations. . Stress Tests under IRB: A bank should ensure that it has sufficient capital to meet the Pillar 1 requirements and the results, in case of a deficiency, of the credit risk stress test performed as part of the Pillar 1IRB minimum requirements. Supervisors may review how the stress test has been carried out and in case of a shortfall, react appropriately. Residual risks: Supervisors should require banks to have in place appropriate and effective written CRM policies and procedures in order to control the residual risks, such as. Inability to seize or realize in a timely manner collateral pledged, refusal or delay by a guarantor to pay and ineffectiveness of untested documentation. K.G. MITTAL COLLEGE OF COMMERCE 21
  22. 22. THE CORPORATE GOVERNANCE OF BANK Credit Concentration Risk: Supervisors should assess the extent of a bank’s credit risk concentrations, how they are managed and the extent to which the bank considers them in its internal assessment of capital adequacy. Such concentrations include a significant exposure to an individual counterparty or group of related counterparties, exposures to counterparties whose financial performance is dependent on the same activity or commodity. Securitization : Further to the Pillar 1 principle that banks should take account of the economic substance of transactions in their capital adequacy determination, supervisors should monitor whether banks have done so adequately. As a result, regulatory capital treatments for specific securitization exposures may exceed those specified in Pillar 1. The supervisors will have to address the key issues involving securitization transactions such as significanceofrisk transfer, market innovations, provision of implicit support,first loss credit enhancements, call provisions and early amortization. Supervisory Transparency and Accountability Basel II Recognizes that the supervision of banks is not an exact science and, therefore, discretionary judgements in the process are inevitable. Therefore, supervisors need to carry out their review in a highly transparent and accountable manner. Supervisors should make publicly available the criteria used in the review of banks’ internal capital assessments. Where the capital requirements are set above the minimum for an individual bank, the supervisors should explain to the bank the risk characteristics specific to the bank that resulted in the requirement. K.G. MITTAL COLLEGE OF COMMERCE 22
  23. 23. THE CORPORATE GOVERNANCE OF BANK Chapter 4 Bank Performance and Corporate Governance Financial Condition of US Banks Last year was exceptional in many respects, with the United States slipping into a recession, the September terrorist attacks, the stock market declines, and all of the related events. In response, the Federal Reserve reduced interest rates at every meeting of the Federal Open Market Committee in 2001 and an additional three times between meeting, for a total of eleven rate cutes accumulating to 475 basis points. The direct effect of the past year’s stressful events were painful enough. In addition, abusive accounting and corporate governance practices made conditions worse, as large corporate bankruptcies imposed substantial losses on investors, lenders, and employees. Throughout this period the US banking system remained strong, reporting continuing record earnings and profitability, despite a slip in asset quality. During the first half of this years, US insured commercial banks earned more than $44.5 billion and an annualized return on assets of 1.37 percent . Net interest income was the primary driver of increased revenue, despite a notable decline in commercial loan volume. Loans loss provisions remained relatively high by the standards of most of the past decade but dipped notably from the second half of 2001. Net charge –offs, which were concentrated among commercial loans of large banks and credit card specialty lenders, also dropped. As noted current weaknesses appear to be largely within the commercial loan portfolios of large regional and money center banks rather than those of smaller institutions. Even the problems of large banks could be viewed as mild, however, given the shocks felt by many in their customer base. Bank performance also reflects, I believe, a grater awareness by institutions K.G. MITTAL COLLEGE OF COMMERCE 23
  24. 24. THE CORPORATE GOVERNANCE OF BANK throughout the banking system that they should promptly address problem as they emerge. If smaller banks, generally, are not seeing the commercial loan weakness that some large institution are facing, which areas may present them with heightened risks? Most Reserve Banks are reporting generally weak commercial real estate markets, as failing companies vacate office and retail space and renters into single family homes commercial real estate credits are still performing relatively well for this stage of the cycle, and my comments are not intended to suggest a material concern. The second areas of potential risk relates to interest rates. For the industry overall, the Federal Reserve’s interest rate cuts last year certainly appear to have helped bank earnings, but they present management with new challenges, too. Lower rates Undoubtedly eased payment pressures on many borrowers, and prevented further deterioration in the quality of bank loan portfolios. Indeed, many banks have responded to the low rates by sharply reducing their investments in Treasuries and shifting funds into mortgage-backed securities in the search for higher yields. That banking organizations, and investors generally, should recognizes that domestic interest rates are historically low and that the possibility for a rising rate environments should not be overlooked. Even stable rates could present increased risks, if saving and money market deposit accounts flow out of banks as quickly as they came in when equity markets declined. At some point, even loyal customers- those on fixed income, in particular-may blink and take steps to improve their own yields. Managing Risks The health of financial institutions today is also a result of improvement in the risk management process that has been ongoing at banks for years, Increasingly, the entire risk management process has become data at lower cost, but also improved techniques for measuring and managing risks. K.G. MITTAL COLLEGE OF COMMERCE 24
  25. 25. THE CORPORATE GOVERNANCE OF BANK As you are aware, bank regulators are working to develop a more modern international approach to bank capital- called Basel II. Although those standards, in the fist instance, are being designed to address changing practices at large, internationally active banks, we can expect the lessons learned about risks management to have much border effects. In quantifying credit risk, large banking organizations are taking the lead, measuring a borrower’s probability of default, the bank’s loss given default and its likely exposure to the borrower at the time of default, taking into consideration future draw downs. The greater of credit scoring in retail transactions provides a stronger framework to asses risk and ensure that loan pricing reflects the credit quality. Such tools should perform even better as the effects of the most recent economic slowdown are incorporated into bank statistics. The measurement and management of interest rate risk has also improved greatly in recent years, perhaps particularly at community banks. Asset. liability committees at banks throughout the country now routinely consider the results of models developed either internally or by vendors to identify the market sensitivity of loans, investments, and deposits. Recent abuses of corporate accounting practices and other matters provide good lessons in risk management as bankers try to increase earning by cross- selling more products, Given the dominant role of credit risk at banks, to chief credit officer should ensure that pressures to increase fee income do not lead to unacceptable levels of credit risks. Corporate Governance (Sound corporate governance is an essential of a strong risk management process. As banker and bank and bank directors ,you have specific responsibilities to manage the risk at your financial institutions and effectively oversee the systems of internal controls) Not only are the activities of central to credit intermediation, but ,in this country , banks found their activities in part with federally insured deposits. Those deposits are the lowest – cost source of found that banks have, specifically because of the government guarantee. K.G. MITTAL COLLEGE OF COMMERCE 25
  26. 26. THE CORPORATE GOVERNANCE OF BANK (Bank directors are not expected to understand every nuance of banking or to oversee each transaction. They can look to management for that) They do, however, have the responsibility to set the tone regarding their institution’s risk taking and to oversee the internal-control processes so that they can reasonably expect that their directives will be followed (They also have the responsibility to hire individuals who they believe have integrity and can exercise a high level of judgment and competence. In the light of recent events , I might add that directors have the further responsibility to periodically consider whether their initial assessment of management’s integrity remains correct. Interagency policy holds boards of directors responsible for ensuring that their organizations have an effective audit process and internal controls that are adequate for the nature and scope of their businesses. Internal audit is a key element of management’s responsibility to validate the strength of a bank’s internal controls. Internal controls are the responsibility of line management. Line managers must determine the level of risk they need to accept to run businesses and must assure themselves that the combination of earnings, capitel, and internal controls is sufficient to compensate for the risk exposures. The results of these independent reviews should be routinely reported to executive management and boards of directors. The level of independence form executive management that a board can demonstrate has, of course, become a far more visible and more important factor in evaluating corporate governance. Other provisions of the act set forth potentially broad ranging standards affecting the way public companies compensate their executives and directors and disclose their operating results. To strengthen the role of outside auditors, the act also limits the non-audit work such firms may perform for audit customers and creates an oversight board to regulate and oversee audit work. K.G. MITTAL COLLEGE OF COMMERCE 26
  27. 27. THE CORPORATE GOVERNANCE OF BANK Indeed, beyond legal requirements, boards of directors and managers of all firms should periodically test where they stand on business practices. They should ask, for example, “ Are we getting by on technicalities, adhering to the letter but not the spirit of the law ? Are we compensating ourselves and others on the basis of contribution, or are we taking ad vantage of our position?” Ultimately, of course, market correct their excesses, and in this context” markets” include both the public and private sectors. Obviously , during the past year we’ ve seeen reactions not only form investors and creditors, but also from law- makers and regulators, to observed failures within corporate boardrooms. All of the action affect market practice. That includes maintaining sound ethical practices in protecting the reputations of your banks. As we have seen from recent events, the market’s response can be harsh. Quality of Accounting practices Uncertainty regarding the quality of corporate accounting standards strikes at the heart of our capitalist system and threatens the efficiency of markets. Investors and leders must be confident that understand the risk they accept and that their counterparties are playing fair. Informed and objective professionals can legitimately disagree on the best accounting standard to apply to new types of tranasacations .That is part of the challenge of keeping accounting standards current. The rapid pace of business innovations makes it impractial to have rules in place to anticipate every business transacation. At the core of such accounting principles should be professional standards that every corporate accountants and every outside auditor must follows. In part, auditors should be required to ask themselves whether a particular accounting method adequately represents the economics of tranasacation and whether it provides readers with sufficient information to evaluate the risks. K.G. MITTAL COLLEGE OF COMMERCE 27
  28. 28. THE CORPORATE GOVERNANCE OF BANK Rules alone, however, do not ensure good financial reporting. At Enron and other companies, weak corporate governances practices apparently permitted sham tranasactions and misleading financial reporting. Outside auditors erred in trying too hard to pleasean important client. For its part, the Federal Reserve is also willing to challenge accounting interpretations that it sees as too aggressive. In another example, the banking regulators have jointly issued for comment new guidance related to credits cards. This guidance not only deals with unacceptable practices, but also clarifies that revenue recognition of fees billed to customers should the expected ability to collect those fees. K.G. MITTAL COLLEGE OF COMMERCE 28
  29. 29. THE CORPORATE GOVERNANCE OF BANK Chapter 5 The Role Of The Central Bank In Promoting Corporate Governance The growing competitiveness and interdependence between Banks and financial institutions in local and foreign markets Have increased the importance of corporate governance and Its application in the banking sectpr.corporate governance in Bank can be achieved through a set of legal, accounting Financial and economic and integrity in banking sector is Maintained , the need for uniform standards of the concept Of governance in private and public sector banks in emphasized. The globalization process and the liberalization of money markets have changed the ideas and visions of financial institutions all over the world. Banks and financial institutions in local and foreign markets have acquired a new spirit of competitiveness. Governance in the banking sector is achieved through a set of legal, accounting, Financial and economic rules and regulations. These rules and regulations direct the Management, govern performance , and assist in carrying out the responsibilities of the Sector. Corporate governance is important because it prohibits corruption , ensures integrity and also ensures. Corporate governance is important as well to benefit and learn from the finding of the auditors and financial controllers and to understand their oversight role. K.G. MITTAL COLLEGE OF COMMERCE 29
  30. 30. THE CORPORATE GOVERNANCE OF BANK Role of central Bank Over the last yars, the central bank of Egypt has adopted a number of measures that are consistent with principles set by the basel committee on banking supervision .these measures are within the legal and regulatory framework of the role of the central bank In the area of prudential regulation and effective surveillance of the daily operations of banks. Setting a percentage of liquidity and reseves for banks is considered a prudential mechanism and not a requirement that hinders banking activity. Over the last years, some were complaining that banks are hindered by an elevated percentage of legal reserves , and that is the reason for the liquidity crisis. Bankers know very well how to manage their banks; the central banks is here to assist the bankers, at the same time trigger the warning Bell should such a situation arise. The central bank of Egypt also emphasizes the measure of loan concentration at the level of each bank. Loan concentration is not related to the loan provided to one client . currently the law sets the exposure limit to each client at 30 percent . we also have loan concentration limits for foreign banks . the restriction is that all egyptlion money or all egyption money or all egyption originated money should not be deposited at foreign representation banks. However connections related to more than one activity will lead a bank to be exposed to problems that have been avoided to conneted lending last November 2002 There will be a conflict of interest. You cannot be a borrower and a shareholder in the same time. Certainly, there will be a confict of interest between your position as a shareholder who wants to puesue the maximum profit and a borrower The same to the member of the boards of directors. We emphasize that the member of the board of directors. We emphasize that the member of board of K.G. MITTAL COLLEGE OF COMMERCE 30
  31. 31. THE CORPORATE GOVERNANCE OF BANK directors shoud not be a borrower from the same bank; otherwise things will be mixed up and there will be conflict of interests. Direct conflict of interst, each non-executive board member should sign a certification and submit it to the board of the bank sating that he has no conflicts of interst and that he will refrain from mixing his private work or business and his work as a board member. It is advisable that audit committees have three non-executive board members. Committee members should be given power and authority to review the bank’s performance, works, disciple, and manuals, and the extent of their compliance to the manuals. The report of the auditing committee should be available for the whole board for revision and the finding should be presented by the head of the auditing committee. If the bank’s auditing committees follow internationally recognized standards and practice, I think that there will be some sort of adherence to the discipline. The establishment of inspection committee or department is not the issue; the issue is these department of inspection committees or departments is not the effective. If inspection committees sumit their report to the chairman of the board of directors, we should say that this is wrong. These committees needs to submit reports and make its information available to the entire board of directors, and not to the chairan or executive director. I think there is no contradiction between the internal inspection departments and internal auditing committees . Infection departments have a daily responsibility to check compliance with manuals . Shareholders Rights It is very important that the shareholders have the conviction to take and to give. In many cases , we find that shareholders in companies not to speak of banks, are interested only only to no about their dividends . if we assume that this is the right think to do than, there controlling role is absent . Some share K.G. MITTAL COLLEGE OF COMMERCE 31
  32. 32. THE CORPORATE GOVERNANCE OF BANK holders want only to receive decedents has investors but are not aware that they have controlling and supervisory role Shareholders need to undertake their supervisory role within all institutions. We as a supervisory institution for the banking sector should perform our role so, if there is internal control at the banking via corporate governance and external controls from the central bank, this would be very beneficial to the country. If we look at the control factor inside the banks boards and make a link between members of the banks boards of directors and their ownership we might discover that a specific shrereholder might control the banks management and control its decisions. Ownership might be 49 percent ina specific institutions and other ownership might be 20 or 21 percent and be consider it a sister company and not an affiliated company In the coming period, we are concerned with new bank laws and we will make sure that the concept of control leads to quality and not to monopoly. Monopoly of thought and monopoly of leadership in the bank in a wrong direction or leading the board in a wrong direction will be given enough consideration. Corporate governance criteria can not be effective if it is only on paper. Proper, sound, and effective corporate governance criteria are those that incorporate a punishment and reward system. The central bank’s ability to implement its policies and decisions within the banking sector serve as a corrective and disciplinary mechanism. The bank’s board of director and it’s general assemblies also need to be committed to undertaking corrective measures when necessary. When, for example, the audit committees in the banking sector notifies the board about some specific audit findings, the board needs to immediately take corrective measures rather than rushing to defend its decisions or before rushing into defending the executive management of the bank, as it is possible that the executive might be wrong .The central bank also needs to be effective in implementing measures when discovering malpractices in the banking sector or the performance of the banks boards of directors, without using double standardsrecognized criteria. Everyday there are new concepts. K.G. MITTAL COLLEGE OF COMMERCE 32
  33. 33. THE CORPORATE GOVERNANCE OF BANK Chapter 6 Public Sector Banks and The Governance Challenge Historical Concept India had a fairly well developed commercial banking system in existence at the time of independence in 1947.The Reserve Bank of India (RBI) was established in 1935.While the RBI became a state-owned institution from January 1, 1949, the Banking Regulation Act was enacted in 1949 providing a framework of regulation and supervision of commercial banking activity. The first step towards the nationalization of commercial banks was the results of a report (under the aegis of RBI) by` the Committee of Direction of All India Rural Credit Survey (1951) which till today is the locus classicus on the subject .Thus the Imperial Bank was taken over by the Government and renamed as the State Bank of India(SBI)n the July 1,1955 with the RBI acquiring overriding substantial holding of shares. A number of erstwhile banks owned by princely states were subsidiaries of SBI in 1959. To meet theses concerns, in 1967 , the Government introduced the concept of social control in the banking industry . The scheme of social control was aimed at bringing some changes in the management and distribution of credit by the commercial banks. Political compulsion then partially attributed to inadequacies of the social control, led to the Government of India nationalizing, in 1969, 14 major scheduled commercial banks the needs which had deposits above a cut-off size. The objective was to serve better the needs of development of the economy in conformity with national priorities and objectives. From the fifties a number of exclusively state-owned development financial institution (DFIs) were also set up both at the national and state level, with a K.G. MITTAL COLLEGE OF COMMERCE 33
  34. 34. THE CORPORATE GOVERNANCE OF BANK lone exception of Industrial Credit and Investment Corporation of India (ICICI) which had minority kprivcate share holding. Reform Measures The major challenge of the reform has been to introduce elements of market incentive as a dominant factor gradually replacing the administratively coordinated planned actions for development. Such a paradigm shift has several dimensions, the corporate governance being one of the important elements. The evolution of corporate governance in banks, particularly in PSBs, thus reflects changes in monetary policy, regulatory environment, and structural transformations and to some extent, on the character of the self- regulatory organizations functioning in the financial sector. Policy Environment During the reform period, the policy environment enhanced competition and provided greater opportunity for exercise of what may be called genuine corporate element in each bank to replace the elements of coordinated actions of all entities as a “joint family “ to fulfill predetermined Plan priorities . The measures taken so far can be summarized as follows. First, greater competition has been infused in the banking system by permitting entry of private sector banks (9licences since 1993), and liberal licensing of more branches by foreign banks and the entry of new foreign banks. With the development of a multi- institutional structure in the financial sector non-bank intermediation has increased, banks have had to improve efficiency to ensure survival. Second, the reforms accorded greater flexibility to the banking system to manage both the pricing and quantity of resources. There has been a reduction in statutory preemptions to less than a third of commercial banks resources. Valuation of banks’ investments is also attuned to international best practices so as to appropriately capture market risks. K.G. MITTAL COLLEGE OF COMMERCE 34
  35. 35. THE CORPORATE GOVERNANCE OF BANK Third, the RBI has moved away from micro-regulation to macro-management. RBI has replaced detailed individual guidelines with general guidelines and now leaves it to individual banks’ boards to set their guidelines on credit decisions. Fourth, to strengthen the banking system to cope up with the changing environment , prudential standards have been imposed in a progressive manner. Fifth, an appropriate legal., institutional, technological and regulatory framework has been put in place for the development of financial markets. There is now increased volumes and transparency in the primary and secondary market operations. Development of the Government Securities, money and forex markets Interest rate channel of monetary policy transmission is acquiring greater importance as Compared with the credit channel . Regulatory Environment Prudential regulation and supervision have formed a critical component of the financial sector reform programme since its inception, and India has endeavoured to international prudential norms and practices. The Banking Regulation Act 1949 prevents connected lending (i.e. lending by banks to directors or companies in which Directors are interested. Periodical inspection of banks has been the main instrument of supervision, though recently there has been a move toward supplementary ‘on-site inspections’ with ‘off-sites surveillance’. The system of ‘Annual Financial Inspection’ was introduced in1992, in place of the earlier system of Annual Financial Review/Financial Inspections. A high powered Board for Financial Supervision (BFS), comprising the Governor of RBI as Chairman, one of the Deputy Governors as Vice- chairman and four Directors of the central board of RBI as members was constituted in 1994 , with the mandate to exercise the Power of supervision K.G. MITTAL COLLEGE OF COMMERCE 35
  36. 36. THE CORPORATE GOVERNANCE OF BANK and inspection in relation to the banking companies , financial institution and non-banking companies. A supervisory strategy comprising on- site inspection , off –site monitoring and contral systems internal to the banks , based on the camels (capital adequacy, asset quality , management , earnings , liquidity and systems and controls ) methodology for banks have been instituted . the RBI has instituted a mechanism for critical analysis of the balance sheet by the banks themselves and the presentation of such analysis before their boards to provide an internal assessment of the health of the bank. Keeping in line with the merging regulatory and supervisory standards at international level , the RBI has initiated certain macro level monitoring techniques to assess the true health of the supervised institutions. The format of balance sheets of commercial banks have now been prescribed by the RBI with discosuresure standards on vital performance and growth indicators , provisions, net NPAs, staff productivity , etc. appended as ‘notes of accounts’. These proposed additional disclosure norms would bring the disclosure standards almost on par with the international best practice. Structural Environment Of Banking The nationalized banks are enabled to dilute their equity of Government of India to 51 percent following the amendment to the Banking Companies (Acquisition & Transfer of Undertakings) Acts in 1994, bringing down the minimum Government’s shareholder to 51 percent in PSBs. RBI’s shareholding in SBI is subject to a minimum of 55 percent. The diversification of ownership of PSBs has made a qualitative difference to the functioning of PSBs since there is induction of private shareholding and attendant issues of shareholder’s value, as reflected by the market cap, representation on board, and interests of minority shareholders. There is representation of private shareholder when the banks raise capital from the market. The governance of banks rests with the board of directors. In the light of deregulation in interest rates and the greater autonomy given to banks in their operation, the role of the board of directors has become more signification. K.G. MITTAL COLLEGE OF COMMERCE 36
  37. 37. THE CORPORATE GOVERNANCE OF BANK During the years, Board have been required to lay down policies in critical areas such as investments, loans, asset- liability management, and management and recovery of NPAs. As part of this process, several Board level committee including the Management Committee are required to be appointed by banks. Government introduced a Bill in Parliament to omit the mandatory provisions regarding appointment of RBI nominees on the Boards of public sector banks and instead to add a clause to enable RBI to appoint its nominee on the boards of public sector banks if the RBI is of the opinion that in the interest of the banking policy or in the public interest or in the interest of the bank or depositors, it is necessary so to do. Appointment of Chairman and Managing Directors and Executive Derectors of all PSBs is done by Government., The Narasimham Committee II had recommended that the appointment of Chairman and Managing Director should be left to the Boards of banks and the Boards themselves should be elected by shareholders Appointment as well as removal of auditors in PSBs require prior approval of the RBI. There is an elaborate procedure by which banks select auditiors from an approved panel circulated by the RBI. In respect of private sector banks, the statutory auditors are appointed in the Annual General Meeting with the prior approval by the RBI. Self Regulatory Organisations India has had the distinction of experimenting with Self Regulatory Organisation (SROs) in the financial system since the pre-independence days. At present, there are four SROs in the financial system- Indian Banks Association (IBA), Foreign Exchange Dealers Association of India (FEDAI), Primary Dealers Association of India (PDAI) and Fixed Income Money Market Dealers Association of India (FIMMDAI). The IBA established in 1946 as a voluntary association of bankis, stove towards strengthening the banking industry through consensus and co- K.G. MITTAL COLLEGE OF COMMERCE 37
  38. 38. THE CORPORATE GOVERNANCE OF BANK ordination. Since nationalisation of banks, PSBs tended to dominate IBA and developed close links with Government and RBI. Often, the reactive and consensus and coordinated approach border on cartelisation. To illustrate, IBA had worked out a schedule of benchmark service charges for the services rendered by member banks, which were not mandatory in nature, but were being adopted by all banks. Responding to the imperatives caused by the changing scenario in the reform era, the IBA has , over the years, refocused its vision, redefined its role, and modified its operational modalities. In the area of foreign exchange, FEDAI was established in 1958, and banks were required to abide by terms and conditions prescribed by FEDAI for transacting foreign exchange business. In the light of reforms, FEDAI has refocused its role by giving up fixing of rates, but plays a multifarious role covering training of banks’ personnel, accounting standards, evolving risk measurement models like the VaR and accrediting foreign exchange brokers. In the financial markets, the two SROs, viz , the PDAI and the FIMMDAI are closely involved in contemporary issues relating to development of money and government securities markets. The representatives of PDAI and FIMMDAI are members of important committees of the RBI, both on policy and operational issues. To illustrate, the Chairman of PDAI and FIMMDAI are members of the Technical Advisory Group on Money and Government Securities market of the RBI. Current Proposal It would be evident that the Report ofAdvisory Group contain far reaching proposal to improve corporate governance and many if not all do require legislative processes and they are necessarily time consuming and often realisable only in medium-term. While proceeding with analysis and possible legislative actions, it may be necessary to consider and adopt changes that could be brought about within the existing legislative. K.G. MITTAL COLLEGE OF COMMERCE 38
  39. 39. THE CORPORATE GOVERNANCE OF BANK To this end, Governor Jalan in his Monetary and Credit policy statement of October 2001 constituted a consultative Group of Directors of banks and financial institutions (Chairman Dr. A S Ganguly) to review the supervisory role of Boards of banks and financial institutions and to obtain feedback on the functioning of the Boards vis-à-vis compliance, transparency , disclosures, audit committees etc., and make recommendation for making the role of Board of Directors more effective. The Group made its recommendations very recently after a comprehensive review of the existing framework as well as of current practices and benchmarked its recommendations with international best practices and benchmarked by the Basel committee on Banking Supervision, as well as of other committees and advisory bodies, to the extent applicable in the Indian environment. Tentative Issues and Lessons Corporate governance in PSBs is important, not only because PS Bs happen to dominate the banking industry , but also because, they are unlikely to exit from banking business though they may get transformed. To the extent there is public ownership of PS Bs, the multiple objectives of the government as owner and the complex principal- agent relationships cannot be wished away. PS Bs cannot be expected to blindly mimic private corporate banks in governance though general principles are equally valid. Complications arise when there is a widespread feeling of uncertainty of ownership and public ownership is treated as transitional phenomenon. The anticipation or threat of change in ownership has also some impact on governance, since expected change is not merely of owner but the very nature of owner. Mixed ownership where government has controlling interest is an institutional structure that poses issues of significant difference between one set of owners who look for commercial return and another who seeks something more and different, to justify ownership. The most important challenge faced in enhancing corporate governance and in respect of which there has been significant though partial success relates to redefining the interrelationships between institution within the broadly defined public sector i e., K.G. MITTAL COLLEGE OF COMMERCE 39
  40. 40. THE CORPORATE GOVERNANCE OF BANK government ,RBI and PSBs and PSBs to move away from a model of planned development.) The central bank also had to move away from sharing the nitty gritty of developmental schemes with government involving micro regulation, to a more equitable treatment of all banks as regulator and standareds. Another noteworthy aspect of enhancing corporate governance is narrowing of gap between PSBs and other banks in terms of the policy , regulatory and operating environment, apart from some changes in ownership structures with attendant consequences. The PSBs as hundred percent owned entities with no share value quoted in stock exchanges accounted for over three quarters of banking business seven years ago, while they now account for less than a quarter. Random Thoughts The Indian experience provokes some thoughts on a few fundamental issues in regard to PSBs and corporate governance. First, is public ownership compatible with sound corporate governance as generally understood? Since various corporate governance structures exits in different countries . Government ownership of a bank , unless government happens to have such a stake purely as a financial investment for return, necessarily has to have the effect of altering the strategies and objectives as well as structure of government. Government as an owner is accountable to political institutions which may not necessarily be compatible with purely economic incentives. The mixed ownership brings into sharper focus the divergent objectives of shareholding and the issues of reconciling them, especially when one of the owners is government. In such a situation, one can argue that as long as the private shareholder is aware of the special nature of shareholding , ther should be no conflict. It other words, The idea of maintaining public sector character of a bank while government holds a minority shareholding is an intensified and modified K.G. MITTAL COLLEGE OF COMMERCE 40
  41. 41. THE CORPORATE GOVERNANCE OF BANK version of “golden share” experiment of UK. The question could still be as to whether such a mixed ownership of organization, particularly for banks which are in case generally under intense regulation and supervision. There are, however, significant element of subjectivity. Governor Jalan feels that private sectror has greater element of insider model. “Public sector banks/Fls for example, are more akin to the ‘outsider ,model with separation of “Ownership’’ and “Management’’.Private sector banks /NBFCs/co-ops-much more “insider’’modals with families , inter – connected entities or promoters running the management”(Jalan 2002). K.G. MITTAL COLLEGE OF COMMERCE 41
  42. 42. THE CORPORATE GOVERNANCE OF BANK Chapter 7 Best practices of corporate Governance in Banks V subbulakshmi Financial failures like Eron. WorldCom have eroded faith In the corporate sector generating unprecedented shocks in The stock markers all over the world. many individual and Corporate investors have become conservative in their Investment decisions they demand higher degree of scrutiny Of a corprate’s financial disclosure and stringent Disclosure norms to avoid such irreversible and Irrecoverable scandals in the future . consequently, the board Rooms are compelled to pay greater attention to their Relationship with the stakeholders and the transparency of Their financial statements. Legislative and regulatory issues Have also been made more stringent to boost investor Confidence. The audit pocess has also been reviewed Thoroughly with clear guidedlines the focus on corplorate Dities and responsibilities. The focus Historical Context India had a fairly well developed commercial banking system in existence at the time of independence in 1947 The Reserve Bank of India (RBI) was established in 1935. While the RBI became a state-owned institution from January 1,1949, the Banking Regulation Act was enacted in 1949 provinding a framework for regulation and supervision of commercial banking activity. The first step towards the nationalisation of commercial banks was the result of a report K.G. MITTAL COLLEGE OF COMMERCE 42
  43. 43. THE CORPORATE GOVERNANCE OF BANK (under the aegis of RBI) by the Committee of Direction of ALL India Rural Credit Survey (1951 ) which till today is the locus classicus on the subject. Thus, the Imperial Bank was taken over by the Government and renamed as the State Bank of India (SBI) on July 1 , 1955 with the RBI acquiring overriding substantial holding of shares . A number of erstwhile banks owned by princely states were made subsidiaries of SBI in 1959. To meet these concerns , 1967, the Government introduced the concept of social control in the banking industry. The scheme of social control was aimed at bringing some changes in the management and distribution of credit by the commercial banks. Political compulsion then partially attributed to inadequacies of the social control , led to the Government of India nationalizing, in 1969, 14 major scheduled commercial banks which had deposits above a cut-off size. The objective was to serve better the needs of development of the economy in conformity with national priorities and objectives. From the fifties a number of exclusively state- owned development financial institutions (DFIs) were also set up both at the national and state level, with a lone exception of Industrial Credit and Investment Corporation of India (ICICI ) which had a minority private share holding. Reform Measures The major challenge of the reform has been to introduce elements of market incentive as a dominant factor gradually replacing the administratively coordinated planned actions for development . Such a paradigm shift has several dimensions , the corporate governance being one of the important elements. The evolution of corporate governance in banks, particularly, in PSBs, thus reflects changes in monetary policy , regulatory environment, and structural K.G. MITTAL COLLEGE OF COMMERCE 43
  44. 44. THE CORPORATE GOVERNANCE OF BANK transformations and to some extent , on the character of the self - regulatory organisations functioning in the financial sector Policy Environment During the reform period, the policy environment enhanced competition and provided greater opportunity for exercise of what may be called genuine corporate element in each bank to replace the elements of coordinated actions of all entities as a “ joint family” to fulfill predetermined Plan priorities. The measures taken so far can be summarized as follows: First, greater competition has been infused in the banking system by permitting entry of private sector banks (9 licences since 1993 ), and liberal licensing of more branches Foreign banks and the entry of new foreign banks. With the development of a multi- institutional structure in the financial sector. Non- bank intermediation has increased, banks have had to improve efficiency to ensure survival. Second , the reforms accorded greater flexibility to the banking system to manage both the pricing and quantity of resources. There has been a reduction in statutory preemptions to less than a third of commercial banks resources. Valuation of banks ‘ investments is also attuned to international best practices so as to appropriately capture market risks. Third , the RBI has moved away from micro-regulation to macro- management . RBI has replaced detailed individual guidelines with general guidelines and now leaves it to individual banks’ boards to set their guidelines on credit decisions . A Regulation Review Authority was established in RBI, whereby any bank could challenge the need for any regulation or guideline and the department had to justify the need and usefulness for such guideline relative to costs of regulation and compliance. K.G. MITTAL COLLEGE OF COMMERCE 44
  45. 45. THE CORPORATE GOVERNANCE OF BANK Fourth, to strengthen the banking system to cope up with the changing environment, prudential standards have been imposed in a progressive manner. Thus, while banks have greater freedom to take credit decisions, prudential norms setting out capital adequacy norms, asset classification , income recognition and provisioning rules, exposure norms, and asset liability management systems have helped to identify and contain risks, thereby contributing to greater financial stability. Fifth ,an appropriate legal institutional , technological and regulatory framework has been put in place for the development of financial markets. There is now increased volumes and transparency in the primary and secondary market operations . Development of the Government Securities , money and forex markets. Interest rate channel of monetary policy transmission is acquiring greater importance as compared with the credit channel. Importance of Corporate Governance in Banks Corporate Governance is particularly important for banks because 1) Banks play a dominant role in fina ncial systems and economic growth. 2) Banks are the main source of finance for a majority of firms as access of financial markets is subject to compliance with cumbersome regulatory requirements. 3) They are the main depositories for the economy’s saving. 4) They act as the custodian of thew country’s liquid reserves. Thus the banking system deserves much attention to build a strong, reliable And stable financial system in a country .` Good governance can be built based on the business practices adopted by the board of directors and management. Many bank failures in the past have been attributed to inadequate and inefficient management which K.G. MITTAL COLLEGE OF COMMERCE 45
  46. 46. THE CORPORATE GOVERNANCE OF BANK enabled banks to accept low quality assets and assume additional risks that extended beyond the level appropriate for the banks’ capacity. Some of the key element that are identified to be a part of a good governance system at the individual bank level`: 1 management with high integrity, adequate and experience; A comprehensive internal information control system to ensure the decisions if the bank are collective decision; Prudent credit appraisal mechanism thereby limiting the risk exposure; and Effective external and internal audit procedures to establish adherence to the policies and regulations and no special treatment is allowed on any particular decision. Ten Commandments of Corporate Governance We can enumerate the commandments for ensuring bank corporate governance. 1) Banks shall realize the times are changing The issue of corporate governance had not been given the requisite attention in the past until the advent of some economic and financial crises in the late ‘90s. Times are changing now, and even smallest banks need to focus on corporate governance restructuring. This is because of the apparent lack of integrity and values in the operation some large corporations like World Com and Enron. 2) Banks shall establish an effective capable and reliable board of directors Establishing an effective, capable and reliable board of directors requires involving well qualified and successful individuals with integrity. This implies that a majority of banks of board of directors should be truly K.G. MITTAL COLLEGE OF COMMERCE 46
  47. 47. THE CORPORATE GOVERNANCE OF BANK outside independent directors. Here, “independence” refers to the individual not working for the bank and he/she not having material relationship with the bank. The board should set a long-term strategy, policy and values for the organization. Nevertheless, the bank should not micromanage the institution. 3) Banks shall establish a corporate code of ethics for themselves Corporate ethics and values should be established at the top and should be used to govern the operations of the company both from a long-term and a short-term view point. Unless this exercise is accomplished, executive management cannot anticipate that the rank and file employees will follow such a code on their own. A workable, reliable and such a code should be reviewed annually. 4) Banks shall consider establishing an Office of the Chairman of the Board Many banks are already examining this idea of eatablishing Office of the Chairman of the Board. Such an Office will be made to report to the board and will act as the board’s eyes and ears on a daily basis in connection with the functions of the bank. 5) Banks shall have an effective and operating audit committee, compensation committee and nominating/corporate governance committee The audit committee, compensation committee and nominating committee should be composed of all independent, outside directors of the bank who operate independently. These committees should have access to attorneys and consultants paid for by the bank other than the bank’s customary counsel and consultants. This independence of the committees will ensure any bias in the internal audit committee’s decisions. K.G. MITTAL COLLEGE OF COMMERCE 47
  48. 48. THE CORPORATE GOVERNANCE OF BANK 6) Banks shall consider the effective board compensation Fair compensation should be paid to the directors. Their remuneration should be commensurate with the risks they take. The bank should aim to appoint a highly qualified director and take appropriate measures to retain them with the organization as it normally does with other employees. 7) Banks shall require continuing education for directors The financial services industry is now facing a number or challenges due to many technology innovations. Therefore, it becomes imperative for the banks to educate their directors to meet the growing needs of the industry. Continuing education should be given equal importance along with other parameters outlined above. 8) Banks shall establish procedures for board succession The presence of qualified members on the board is a very crucial issue. So a bank should have a clearly specified set of rules regarding issues of succession to the board. The bank should pose a question naire as follows: a) Does the bank have a mandatory retirement age that is actually enforced? b) Does a self appraisal process exist to free the board of the non- productive directors? b) Does the bank have a plan to maintain a fully staffed board of directors with capable people, no matter what the age is as it moves forward? 9) Banks shall disclose, disclose and disclose the information K.G. MITTAL COLLEGE OF COMMERCE 48
  49. 49. THE CORPORATE GOVERNANCE OF BANK Banks will find that disclosure will be quicker and more burdensome than it was in the past. This may be through quarterly letters to the shareholders or other types of communication. 10)Banks shall recognize that duty is to established corporate governance procedures that will serve to enhance shareholder value The primary object of the board of directory is to maximize the shareholder’s wealth. The strategy adopted to achive this objective should now encompass corporate governance procedures and shoud be designed with long-term value for the shareholder in focus. Key Elements of Best Practices in Corporate Governance The Key elements identified are: 1) A strong independent board of directors, 2) Independent Committees, 3) Charter-based Committees than rule-based, 4) Code of conduct or ethics, 5) Transparent accounting practices, 6) Director orientation program and an ongoing training, and 7) Risk Management, Steps taken in India to Improve Corporate Governance in Indian Banks. A consultative group of Directors of banks and financial institutions was set up by the Reserve Bank of India to review the supervisory role of the Boards of banks and financial institutions and to obtain feedback on the K.G. MITTAL COLLEGE OF COMMERCE 49
  50. 50. THE CORPORATE GOVERNANCE OF BANK functioning of the Boards vis-à-vis compliance, transparency, disclosures, audit committees, etc. These recommendations were based on international best practice as enunciated by the Basel Committee on banking supervision, other committee and advisory bodies. But suitable amendments were made in these international standards to suit the Indian scenario. Recommendations of the Advisory Group • Directors of all banks both public and private sector banks should exercise due diligence with respect to their suitability to the post they hold by way of qualifications and technical expertise. • The Government shout be guide by certain broad “fit and proper” norms for the nomination of the Directors. The criteria suggested by Bank of International Settlements can be adopted as a guideline to arrive at an appropriate set of norms . • For assessing integrity and suitability factors such as criminal records, financial position, civil action undertaken to pursue personal debts, refusal of admission to or expulsion from profession bodies, sanction applied by regulation to similar bodies and previous questionable business practices, etc, should be considered. • The appointment / nomination of independent / non- executive directors to the Boards of banks should be taken from a pool of professional and talented people to be prepared and maintained by the country’s Central Bank, Reserve Bank of India. Any violation of the norm should be notified to the RBI. • In the current context of banking becoming more complex and knowledge – based , there is an urgent need for making the boards K.G. MITTAL COLLEGE OF COMMERCE 50
  51. 51. THE CORPORATE GOVERNANCE OF BANK of banks more contemporarily professional by inducting technically and specially qualified individual. • While the existing regulation of appointing experts from different sectors such as agriculture, SSI, etc can be continued , efforts should be aimed at combining it with the need based representation of skills such as marketing , technology and systems , risk management , strategic planning , treasury operations, credit recovery , etc. • The independent and non- executive directors should raise critical questions relating to business strategy , house keeping and internal control systems and other important aspects of the functioning of the bank and investor relations in the meeting of the board. • In the private sector banks where promoter directors may act in concert , the independent / non- executive directors should provide effective checks and balances to ensure that the bank does not build up exposures to entities connected with the promoters or their associates. • The remuneration of the directors should be increased to the comparable levels of international standards to encourage them towards maintaining integrity in their performing the duties. • The office of the chairman and the director should be separated in respect of large sized public sector to bring in more focus in rendering their duties. • The information furnished to the board should be adequate and complete to enable the members of the Board to take meaningful decisions. • Uniform code and procedure should be adopted for recording the proceedings of the Board meetings in banks and financial institutions. K.G. MITTAL COLLEGE OF COMMERCE 51
  52. 52. THE CORPORATE GOVERNANCE OF BANK • The board should be informed periodically of the exposures of a bank to stockbrokers and market- makers and other sensitive sectors such as real estate etc. • All banks should give importance to appointing a qualified Company Secretary as the Secretary to the Board and also appoint a Compliance Officer for monitoring and reporting compliance with regulatory and accounting requirements. • The Audit committee should comprise independent / non-executive directors and the Executive Directors should only be a permanent invitee. • The Chairman of Audit committee need not be necessarily a Chartered Accountant and can be an eminent finance or banking professional too as the committee besides accounting issues takes care of other management issues takes other management issues also. • A nomination committee is recommended for appointing independent / non-executive directors of banks. • In addition to the above committees, it is also recommended to have a Committee of the board that would look into the grievances of the investors and shareholders with the Company Secretary as the Head. • The formation and operationalization of the Risk Management Committees in pursuance of the guidelines issued by the RBI should be speeded up and their role should strengthened further. It is imperative for the government and the RBI to work collectively to bring out significant changes in the corporate governance mechanism adopted by banks and other financial intermediaries . RBI should stay away from appointing its nominees on the Boards of banks to avoid conflicts of interests. K.G. MITTAL COLLEGE OF COMMERCE 52
  53. 53. THE CORPORATE GOVERNANCE OF BANK Banks need to have clear cut, well- defined strategies for guiding their operations and establishing accountability for executing them . Banks should maintain a high degree of transparency in regard to disclosure of information. K.G. MITTAL COLLEGE OF COMMERCE 53
  54. 54. THE CORPORATE GOVERNANCE OF BANK CONCLUSION Corporate governance thus has become a topic interst to Many audience including the corporate directors, the central banks and other regulatory authorities. Like many issues, even CG has become an interesting issue that attracted public attention in the wake of corporate scandals like Enron. Governance issue generally centers around accountability of the parties involved in decision-making in a bank or any organization. Liberalization and deregulation, and volatility in the financial markets are the major factors that have triggered an interest in the issue of corporate governance. This book in this context has made an attempt to introduce the reader the concept, issues and perspectives of corporate governance in the financial sector in general and banks in particular. This is the first book in the series giving a brief introduction on the corporate governance practices in some of the Asian banks and Indian banks. We welcome the suggestions of the readers to improve the contents in our future editions. K.G. MITTAL COLLEGE OF COMMERCE 54