Draft code of mandatory corporate governance for banks

Preamble
The Business of Banks, Public Confidence and the Economy
Banks in Sri Lanka are the apex financial intermediaries licensed by the Monetary Board to carry on business in money, in terms of the Banking Act, the Monetary Law Act and other statutes relating to the financial and payments system. This business mainly includes: (i) raising funds through deposits and debt securities; (ii) lending such funds; and (iii) providing services that facilitate payments.
Banks are, by and large, in business because of the confidence that the public and customers have that banks are (i) safe and sound; (ii) able to repay the deposits and debts; and (iii) able to provide other financial services such as lending and payments services, without interruption. Any potential risk which may damage this public confidence will cause a depositors’ run on banks and cause customers to default on their obligations to banks, which will eventually lead to a liquidity crisis, insolvency and failure of banks. The history of bank failures in many countries shows that a failure of a few banks has a contagion effect on the entire banking system due to damaged public confidence.
The banking system also has a special feature, i.e., the ability to create money through its business. This “created money” is the largest component of the money in circulation available for financing economic transactions. Therefore, the banking business is a public good, and a failure of banks will adversely affect monetary conditions and the economic well-being of the public. The public undertakes transactions (such as making deposits, investments and payments) through various types of payment instruments because of their belief that such monies would serve as legal tender, i.e., currency, or can be converted into currency without delay. Any failure of banks or large-scale withdrawals of deposits may, therefore, lead to a liquidity crisis in the financial system because the amount of money held by the public by way of deposits is significantly greater than the amount of currency in issue or currency held by banks.
A Central Bank cannot guarantee the safety and soundness of each and every bank, although the general public all over the world may expect it to do so. A Central Bank or an equivalent regulator can only promote and facilitate risk management by banks and implement measures to resolve problems facing the banks through regulation and supervision, to the extent it is empowered under the relevant legal provisions. In addition, the conventional moral suasion or the advisory capacity and capability of a Central Bank is a useful instrument to ensure discipline within the banks’ management. However, a Central Bank cannot be the risk manager of a bank because it cannot be a substitute for the bank management to operate the banking business. It should always be clear that the board of directors of a bank is the apex structure of the management of a bank. Consequently, the maintenance of the safety and soundness of banks is the responsibility of those who manage the business of banks. The boards of directors should have the primary responsibility and accountability for risk management of banks, morally and statutorily. While the regulatory and supervisory role of a Central Bank, as the Monetary Authority, enhances public confidence through its regulation and supervision, the moral hazard problem arising from the regulatory and supervisory role of the Central Bank, namely, the tendency for bank customers and bank management to take more risks than they would otherwise take in the absence of regulation and supervision, also needs to be managed.
The maintenance of monetary stability and financial system stability to facilitate economic stability is a key responsibility of the Central Bank of Sri Lanka. The assurance of legal tender of the currency is also a responsibility of the Central Bank.
In these circumstances, the Central Bank has to ensure that banks operate their businesses in a safe and sound manner in the interests of the national economy. As practiced in many other countries as well, it is in this context that banks in Sri Lanka are regulated and supervised by the Central Bank of Sri Lanka.

Evolution of Modern Corporate Governance Practices
Corporate Governance is the management framework that facilitates the boards of directors of institutions to discharge their responsibilities and to be accountable. The corporate scandals that shook many countries in recent years and the adverse impact of the losses suffered by stakeholders of such corporates prompted the speedy development of principles-based modern corporate governance practices.
The application of modern corporate governance practices has become exceedingly popular over recent years and different codes of best practice on corporate governance have been developed by various organisations such as the Organisation for Economic Co-operation and Development (OECD), the Basel Committee on Banking Supervision and the World Bank. In Sri Lanka too, in 1997, the Institute of Chartered Accountants of Sri Lanka issued the first Code of Best Practice on Corporate Governance which was voluntarily adopted and implemented by many corporates. The Securities and Exchange Commission and the Colombo Stock Exchange have also implemented various Corporate Governance practices through its rules and regulations.
Over the past decade or so, several fundamental corporate governance principles have evolved and have gained worldwide acceptance. Comprehensive guidelines under such principles have now been developed by corporate governance activists, practitioners and researchers. These principles generally relate to the responsibilities of (i) the board (ii) the directors, (iii) the chairman, (iv) the chief executive officer, (v) the board appointed committees, and (v) the key management personnel who are in a position to significantly influence policy, direct activities or exercise control over business activities and operations. The broad topics that have been extensively dealt with and targeted in the formulation of these principles and guidelines include (i) accountability, (ii) internal controls, (iii) related party transactions, (iv) conflicts of interests, and (v) information disclosures.
The enunciation of broad Corporate Governance principles actually began in the 19th
Century, although the term “Corporate Governance” itself came into vogue only in the latter part of the 1980s and early 1990s. The need to focus on good corporate governance practices mainly arose as a response to the separation of ownership and control following the formation of joint stock companies in the 19th century. The owners or shareholders of these joint stock companies, who were not involved in day-to-day operational issues, required assurances that those in control of the company, viz., the directors and managers, were safeguarding their investments and accurately reporting the financial and operational outcomes of their business activities. Thus, directors were the original targets of corporate governance, and practices and principles were designed to protect the interests of the shareholders from misdemeanours of directors. However, current thinking recognises a company’s obligations to society more generally in the form of all stakeholders, and it has been this new thinking that has driven the study and practice of good corporate governance to the levels it has reached today.
From the latter part of 2001 onwards, the very lively and often controversial debate on corporate governance entered an even more turbulent phase as a result of a few highly visible and massive corporate scandals and failures, including Enron and WorldCom, which rocked the business world. Almost as a knee-jerk reaction, new laws, e.g. the Sarbanes – Oxley Act in the USA and similar laws and/or regulations in several other countries, were quickly introduced in an attempt to prevent such scandals and failures in future, and to soothe the nervousness of investors.
Accordingly, a number of corporate governance codes were developed by several international organisations and supervisory authorities to guide the boards of directors in corporate governance. Many supervisory and regulatory authorities also implemented mandatory codes of corporate governance in relation to the institutions regulated and supervised by them. For example, the Bank of Thailand issued “A Guideline on the structure of a commercial bank’s governance committee” in December 2002. Subsequently, it issued a directive on “Fit and Proper Criteria for Senior Management of Commercial Banks” in July 2004. In September 2005 the Bank Negara Malaysia (Central Bank of Malaysia) issued “Guidelines on Corporate Governance for Licensed Institutions” covering principles dealing with board matters, management oversight, accountability, audit and transparency. In Sri Lanka too, the Central Bank of Sri Lanka compiled a code of corporate governance through the efforts of a Task Force appointed from the banking industry and such Code was released in June 2002 for the voluntary compliance by banks.
In February 2006, the Basel Committee on Banking Supervision issued an eight principles-based corporate governance scheme to enhance corporate governance for banking organisations. This scheme indicated the need for adoption of corporate governance principles in banks across the world. In the light of the above international developments as well as certain management issues that have surfaced from time to time in relation to banks in Sri Lanka in the recent past, it has now become increasingly important that all banks in Sri Lanka follow a common code of corporate governance in order to regulate these institutions in a uniform manner through the application of market discipline as well. It is believed that this new Mandatory Code of corporate governance will fulfill such need. Towards that end, it has been formulated as a series of rules based upon certain fundamental principles designed to promote a healthy and robust risk management framework for banks, with accountability and transparency through policies and oversight by the boards of directors. It is also likely that this new code would substantially improve governance practices of individual banks. Needless to say, such an outcome would lead to improved confidence in the banking sector and thereby support the prime objective of ensuring and maintaining financial system stability.

The major areas covered by the Mandatory Code would be the following.

• The broad responsibilities of the board
• The board’s composition
• Criteria to assess the fitness and propriety of directors
• Management functions delegated by the board
• The Chairman and the Chief Executive Officer
• Board appointed committees
• Related-party transactions
• Disclosures

The Central Bank of Sri Lanka wishes to thank all those who contributed to the effort to finalise this draft Mandatory Code and looks forward to the co-operation of all concerned in the implementation of the code, in due course. Following is the draft Code.

Section 1 - The Broad Responsibilities Of The Board
Principle
The board of directors should assume the overall responsibility and accountability in respect of (i) the management of the affairs of the bank, i.e., conduct of business and maintenance of prudent risk management mechanisms; and (ii) the safety and soundness of the bank.
Towards this end, the board should: (i) determine the structure of the management of affairs of the bank; (ii) delegate business operations to key management personnel led by the chief executive officer designated by the board; (iii) assume policy making and risk management for the business; and (iv) ensure the effective role of the key management personnel.
The overall responsibility of the board should not be construed as an obligation to undertake the inspection of day-to-day activities, but should rather be understood as an obligation to oversee and ensure that the key management personnel are carrying out the day-to-day activities of the bank in a safe and sound manner in accordance with the policies set by the board.
Directors should understand the business and risk management mechanism of the bank and take objective decisions in the interest of the bank’s depositors, creditors, shareholders and other stakeholders. They should ensure that the bank does not act in a manner that is detrimental or prejudicial to the interests of, and obligations to, depositors.
The board should take the responsibility for compliance with this code of corporate governance. They should also ensure compliance with all regulatory and supervisory requirements and should ensure that an effective combination of professionals with practical experience in relevant subjects such as banking, finance, economics, business management, human resource management, law, marketing, information technology or any other discipline relevant or complementary to banking operations, is available in the bank to undertake its operations and discharge its responsibilities.
The directors should be aware of potential civil and criminal liabilities that may arise from their failure to discharge their duties diligently and also understand that they should act with due care and prudence. The directors of state owned banks must be aware of the additional liabilities that arise from the status of such banks being state enterprises and consequently being accountable to the public. It is, therefore, necessary that directors commit sufficient time and energy to fulfilling the board’s responsibilities in managing the affairs of the bank in a prudent manner.

Rules
1.1 The board shall strengthen the safety and soundness of the bank by ensuring the implementation of the following:

i. Approve and oversee the bank’s strategic objectives and corporate values and ensure that these are communicated throughout the bank;

ii. Approve the overall business strategy of the bank, including the overall risk policy and risk management procedures and mechanisms with measurable goals, for at least the next three years;

iii. Identify the principal risks and ensure implementation of appropriate systems to manage the risks prudently;

iv. Approve implementation of a policy of communication with all stakeholders, including depositors, creditors, shareholders and borrowers;

v. Review the adequacy and the integrity of the bank’s internal control systems and management information systems;

vi. Define the areas of authority and key responsibilities for the Board members themselves and for the key management personnel;

vii. Identify and designate key management personnel who are in a position to:

(i) significantly influence policy;

(ii) direct activities; and

(iii) exercise control over business activities, operations and risk management;

viii. Ensure that there is appropriate oversight of the affairs of the bank by key management personnel, that is consistent with board policy;

ix. Periodically assess the effectiveness of the Board members’ own governance practices, including:

(i) the selection, nomination and election of board members and key management personnel;

(ii) the management of conflicts of interests; and

(iii) the determination of weaknesses and implementation of changes where necessary;

x. Select, monitor, train, fix compensation, and where necessary, replace key management personnel, and ensure that the bank has an appropriate succession plan for key management personnel;

xi. Meet regularly on a needs basis with the key management personnel to review policies, establish communication lines and monitor progress towards corporate objectives;

xii. Understand the regulatory environment and ensure that the bank maintains an effective relationship with regulators;

xiii. Exercise due diligence in the hiring and oversight of external auditors.

1.2 The board shall appoint the Chairman and the Chief Executive Officer and define and approve the functions and responsibilities of the Chairman andthe Chief Executive Officer in line with Rule 5 of this Code.

1.3 The board shall meet regularly and board meetings shall be held at least twelve times a year at approximately monthly intervals. Such regular board meetings shall normally involve active participation in person of a majority of directors entitled to be present. Obtaining the board’s consent through the circulation of written resolutions/papers should be avoided as far as possible.

1.4 The board shall ensure that arrangements are in place to enable all directors to include matters and proposals on the promotion of business and the management of risk in the agenda for regular board meetings.

1.5 The board procedures shall ensure that notice of at least 7 days is given of a regular board meeting to provide all directors an opportunity to attend. For all other board meetings, reasonable notice may be given.

1.6 The board procedures shall ensure that a director who has not attended at least two-thirds of the meetings in the year immediately preceding or has not attended the immediately preceding three consecutive meetings held, shall cease to be a director. Participation at the directors’ meetings through an alternate director who satisfies the criteria applicable to directors under Rule 3 of this code shall, however, be acceptable as attendance.

1.7 The board shall appoint a company secretary who satisfies the provisions of Section 43 of the Banking Act. The primary responsibilities of the secretary would be to handle the secretariat services to the board and shareholder meetings and to carry out other functions specified in the statutes and other regulations.

1.8 All directors shall have access to the advice and services of the company secretary with a view to ensuring that board procedures and all applicable rules and regulations are followed.

1.9 The company secretary shall be responsible for the minutes of board meetings.

The company secretary shall maintain the minutes of board meetings and such minutes shall be open for inspection at any reasonable time, on reasonable notice by any director. Draft and final versions of minutes of board meetings may be sent to all directors for their comments and record within a reasonable time after a board meeting is held.

1.10 Minutes of board meetings shall record in sufficient detail

(i) the matters considered by the board;

(ii) the decisions reached; and

(iii) any concerns raised by directors or dissenting views expressed. It should be possible to gather from the minutes, as to whether the board acted with due care and prudence in performing its duties. The minutes shall also serve as a reference for regulatory and supervisory authorities to assess the depth of deliberations at the board meetings. Therefore, the minutes of a board meeting shall clearly contain the following:

(i) a summary of data and information used by the board in its deliberations;

(ii) the fact-finding discussions and the issues of contention or dissent which may illustrate whether the board was carrying out its duties with due care and prudence;

(iii) the testimonies and confirmations of relevant executives which indicate compliance with the board’s strategies and policies and adherence to relevant laws and regulations;

(iv) the board’s knowledge and understanding of the risks to which the bank is exposed and an overview of the risk management measures adopted; and

(v) the decisions and board resolutions.

1.11 There shall be a procedure agreed by the board to enable directors, upon reasonable request, to seek independent professional advice in appropriate circumstances, at the bank’s expense. The board shall resolve to provide separate independent professional advice to directors to assist the relevant director or directors to discharge his/her/their duties to the bank.

1.12 Directors shall avoid conflicts of interests, or the appearance of conflicts, in their activities with, and commitments to, other organisations or related parties. If a director has a conflict of interest in a matter to be considered by the board, which the board has determined to be material, the matter should be dealt with at a board meeting, where independent non-executive directors (refer to Rule 2.4) who have no material interest in the transaction, are present. Further, a Director shall abstain from voting on any board resolution in which he/she or any of his/her associates has a material interest and he/she shall not be counted in the quorum for the relevant agenda item at the board meeting.

1.13 The board shall have a formal schedule of matters specifically reserved to it for decision to ensure that the direction and control of the bank is firmly under its responsibility.

1.14 The board shall, if it considers that the bank is, or is likely to be, unable to meet its obligations or is about to become insolvent or is about to suspend payments due to depositors and other creditors, forthwith inform the Director of Bank Supervision of the situation of the bank prior to taking any decision or action.

1.15 The board shall ensure that the bank is capitalised at levels required by the Monetary Board in terms of the capital adequacy levels as set out by Bank for International Settlements in Basle and other prudential grounds.

1.16 The board shall make an annual corporate governance report assessing the compliance with this code of corporate governance and publish the report in the bank’s Annual Report. Further, the board shall adopt a scheme of self assessment to be undertaken by each director annually and maintain records of such assessments.

Section 2 - Board’s Composition
Principle
The Board should be composed of a healthy mix of executive directors and nonexecutive directors. Some of the non-executive directors should also be independent so that there is strong independent element brought into the decision-making process.

The Board composition should ensure a balance of skills and experience as may be deemed appropriate and desirable for the requirements of the bank.

The banking industry worldwide is making tremendous progress and undergoing rapid change with new innovations, instruments, technologies, products, systems, and processes being introduced regularly. It is vital therefore, that the directors should be persons who would

(i) be able to keep abreast with these changes and

(ii) provide continuous contributions and guidance to the board decision making process.

There should be a gradual infusion of new ideas into the board. There should also be assurance that the relationships between the directors amongst themselves as well as between the directors and the key management personnel is at a level that does not suggest a relationship that is too close or cozy. In this context, it should be noted that very long-standing relationships could sometimes impair the high sense of values, independence, and objectivity that is needed in the discharge of the duties of a director of a bank.

Rules
2.1 The number of directors on the board should not be less than 7 and not more than 13.

2.2 The term of office of a director other than a director who holds the position of chief executive officer shall not exceed nine years, and such period in office shall be inclusive of the term of office served by such director upto January 1, 2008.

In this context, the following transitional provisions shall apply.

(i) In the event that there is only one director on the board who has served more than nine years as at January 1, 2008, he/she shall be deemed to have vacated the office as a director as at December 31, 2008.

(ii) In the event that there are two or more directors on the board who have served more than nine years as at January 1, 2008, the following provisions shall apply, subject also to the provisions in Rule 3.1:

a. Of those directors whose period of service has exceeded nine years, the longest serving director, shall be deemed to have vacated office as a Director on December 31, 2008.

b. Thereafter, at the end of each succeeding year, the remaining directors shall be deemed to have vacated office in sequence, at least one director each year, (on the basis of the longest to the shortest length of service as a director), until all directors who have served a period in excess of nine years as at January 1, 2008, have been deemed to have vacated office. Provided also, that all directors of the bank who have served more than nine years as at January 1, 2008 shall be deemed to have vacated their office by or before December 31, 2011.

2.3 An employee of a bank may be appointed, elected or nominated as a director of the bank (hereinafter referred to as an “executive director”) provided that the number of executive directors shall not exceed one-third of the number of directors of the board. In such an event one of the executive directors shall be the chief executive officer of the bank.

2.4 The board shall have at least three independent non-executive directors or one third of the total number of directors, whichever is higher. A nonexecutive director shall not be considered independent if he/she:

i. has direct and indirect shareholding of more than 1% in the bank or in a subsidiary company or an associate company of the bank;

ii. currently has or had during the period of two years immediately preceding his/her appointment as director, business transactions with the bank as defined in Rule 7, exceeding 10% of the regulatory capital in the bank;

iii. has been employed by the bank during the two year period immediately preceding the appointment as director;

iv. has a close relation who is a director or chief executive officer or a member of key management personnel or a material shareholder of the bank or another bank. A “close relation” shall mean the spouse or a financially dependant child;

v. represents a specific stakeholder of the bank;

vi. is an employee or a director or a material shareholder in a company or business organization:

a. which currently has a transaction with the bank as defined in Rule 7 of this code, exceeding 10% of the regulatory capital of the bank, or
b. in which any of the other directors of the bank ARE employed or is a director or a material shareholder;

or c. in which any of the other directors of the bank have a transaction as defined in Rule 7 of this code, exceeding 10% of regulatory capital in the bank;

2.5 In the event an alternate director is appointed to represent an independent director, the person so appointed shall also meet the criteria that applies to an independent director.

2.6 In circumstances where a bank has one or more shareholders having material interests as defined in Section 12(1C) of the Banking Act, the board shall include a sufficient number of directors to represent the interests of shareholders who hold interests less than 5% of the issued shares carrying voting rights of the bank.

2.7 Non-executive directors shall be persons of sufficiently high calibre with credible track records and have necessary skills and experience to bring an independent judgment to bear on issues of strategy, performance and resources.

2.8 A meeting of the board shall not be duly constituted, although the number of directors required to constitute the quorum at such meeting is present, unless more than one half of the number of directors present at such meeting are non-executive directors.

2.9 The independent non-executive directors shall be expressly identified as such in all corporate communications that disclose the names of directors of the bank. The bank shall disclose the composition of the board, by category ofdirectors, including the names of the chairman, executive directors, nonexecutive directors and independent non-executive directors in the Corporate Governance Report.

2.10 There shall be a formal, considered and transparent procedure for the appointment of new directors to the board. There shall also be procedures in place for the orderly succession of appointments to the board.

2.11 All directors appointed to fill a casual vacancy shall be subject to election by shareholders at the first general meeting after their appointment.

2.12 If a director resigns or is removed from office, the board shall (i) announce the director’s resignation or removal and the reasons for such removal or resignation including but not limited to information relating to the relevant director’s disagreement with the bank, if any; and (ii) issue a statement confirming whether or not there are any matters that need to be brought to the attention of shareholders.

2.13 A director or an employee of a bank shall not be appointed, elected or nominated as a director of another bank except where such bank is a subsidiary company or an associate company of the first mentioned bank.

Section 3 - Criteria To Assess The Fitness And Propriety Of Directors
Principle

A director should be a fit and proper person in order to be eligible to hold office as a director of a bank. No person should serve as a director unless such person is a fit and proper person.

There is strong need for commitment and effective contribution to the prudent management of the affairs of the bank. The effectiveness of such contribution would tend to decrease with advanced age.

Rules / Criteria
Subject to and in addition to provisions of Section 42 of the Banking Act, the criteria given below shall apply to determine the fitness and propriety of a director. Noncompliance with any one of the items in the criteria shall disqualify a person to be appointed, elected or nominated as a director or to continue as a director.

3.1 The age of the person shall not exceed 70 years. If however, a director who is currently serving at a bank is or is over 70 years of age as at January 1, 2008, subject also to any other provisions of this Code and other statutes, such director may continue to function as a director for a further period that shall not extend beyond December 31, 2009, and shall be deemed to have vacated office on December 31, 2009.
3.2 The person shall possess academic or professional qualifications or effective experience in economics, banking, finance, business, human resource management, law, marketing, information technology or any other discipline relevant or complementary to, banking operations;

3.3 The person shall not hold office as a director of more than 20 companies/entities/institutions inclusive of subsidiaries or associate companies of the bank. Of such 20 companies/entities/institutions, not more 21 than 10 companies shall be those classified as Specified Business Entities in terms of the Sri Lanka Accounting and Auditing Standards Act No. 15 of 1995.

3.4 The person shall not have committed or have been connected with the commission of, any act which involves fraud, deceit, dishonesty or any other similar type of improper conduct. Further, there should have been no finding by any regulatory or supervisory authority, professional association, commission of inquiry, tribunal or other body established by law in Sri Lanka or abroad, to the effect that such person has committed or has been connected with, the commitment of any act which involves fraud, deceit, dishonesty or any other similar type of improper conduct.
3.5 The person shall not be the subject of an investigation or inquiry or hearing consequent upon being served with notice of a charge involving fraud, deceit, dishonesty or other similar type of improper conduct, by any regulatory authority, supervisory authority, professional association, commission of inquiry, tribunal or other body established by law in Sri Lanka or abroad;

3.6 The person shall not have been convicted by any Court in Sri Lanka or abroad in respect of a crime committed in connection with financial management or of any offence involving moral turpitude;

3.7 The person shall not be an undischarged insolvent nor been declared a bankrupt in Sri Lanka or abroad;

3.8 The person shall not have failed to satisfy any judgment or order of any Court, whether in Sri Lanka or abroad, to repay a debt;

3.9 The person shall not have been declared by a court of competent jurisdiction in Sri Lanka or abroad, to be of unsound mind;

3.10 The person shall not have been removed or suspended by an order of a regulatory or supervisory authority from serving as a director, Chief Executive Officer or other officer in any bank or financial institution or corporate body, in Sri Lanka or abroad;

3.11 The person shall not have been a director, Chief Executive Officer or held any other position of authority in any bank or financial institution (i) whose license has been suspended or cancelled; or (ii) which has been wound up or is being wound up; or (iii) which is being compulsorily liquidated whether in Sri Lanka or abroad;

Section 4 - Management Functions Delegated By The Board
Principle

The board should have a formal schedule of matters specifically reserved to it for decision. The board should give clear directions to key management personnel as may be designated by the board, as to the matters that must be approved by the board before decisions are made on behalf of the bank.

Rules
4.1 The directors shall clearly understand the delegation arrangements in place.

In that context, when the board delegates aspects of its management functions to key management personnel, it shall, at the same time, give clear directions as to the powers of key management personnel, in particular, with respect to the circumstances where key management personnel should report back and obtain prior approval from the board before making decisions or entering into any commitments on behalf of the bank.

4.2 The board shall not delegate matters to a board committee, the Chief Executive Officer, executive directors or key management personnel to an extent that would significantly hinder or reduce the ability of the board as a whole to discharge its functions.

4.3 The board shall review the delegation process in place on a periodic basis to ensure that they remain relevant to the needs of the bank.
4.4 The bank shall disclose the division of responsibilities between the board and key management personnel to assist those affected by corporate decisions to better understand the respective responsibilities and contributions of the board and key management personnel.

Section 5 - The Chairman And The Chief Executive Officer
Principle

There are two key aspects of the management of every bank, viz., governance by the board and the day-to-day management of the bank’s business by the CEO, in line with board approved strategic objectives, corporate values, overall risk policy and risk management procedures. There should be a clear division of these responsibilities at the board level and the executive management level to ensure a greater balance of power and authority so that powers are not concentrated in any one individual. In each bank, the board should appoint a chairman as well as a chief executive officer. The role of the chairman should be the overall governance of the bank through the board, whereas the role of the chief executive officer should be that of the apex executive in-charge of the day-to-day management of the bank’s business, in compliance with strategies and policies approved by the board. The division of responsibilities between the chairman and chief executive officer should be clearly established and set out in writing.

Rules
5.1 The roles of chairman and chief executive officer shall be separate and shall not be performed by the same individual.

5.2 The chairman shall be a non-executive director and preferably an independent director as well. In the case where the chairman is not an independent director, the board shall designate an independent director as the Senior Director with suitably documented terms of reference. The designation of the Senior Director shall be disclosed in the bank’s Annual Report.

5.3 The board shall disclose in its Corporate Governance Report, the identity of the chairman and the chief executive officer and the nature of any relationship (including financial, business, family or other material/relevant relationship(s)), if any, between the chairman and the chief executive officer and the relationships among members of the board.

5.4 The chairman shall provide leadership to the board and ensure that the board works effectively and discharges its responsibilities, and that all key and appropriate issues are discussed by the board in a timely manner.

5.5 The chairman shall be primarily responsible for drawing up and approving the agenda for each board meeting taking into account, where appropriate, any matters proposed by the other directors for inclusion in the agenda. The chairman may delegate such tasks to the company secretary.

5.6 The chairman shall ensure that all directors are properly briefed on issues arising at board meetings and be responsible for ensuring that directors receive in a timely manner adequate information, which must be complete and reliable.

5.7 The chairman shall encourage all directors to make a full and active contribution to the board’s affairs and take the lead to ensure that the board acts in the best interests of the bank.

5.8 The chairman shall facilitate the effective contribution of non-executive directors in particular and ensure constructive relations between executive and non-executive directors.

5.9 The chairman, as the highest level of approving authority for decisions on the bank’s business and operations, shall not engage in activities involving direct supervision of key management personnel or any other executive duties whatsoever.

5.10 The chairman shall ensure that appropriate steps are taken to maintain effective communication with shareholders and that the views of shareholders are communicated to the board.

5.11 The chief executive officer shall function as the apex executive-in-charge of the day-to-day-management of the bank’s operations and business and key management personnel inclusive of management level committees in line with the policies and delegation by the board.

Section 6 - Board Appointed Committees
Principle
The board should appoint separate board committees for audit, selection, remuneration, integrated risk management and such other subjects as determined by the Board to ensure its oversight and control over the affairs of the bank. Where the board appoints a committee, it should set out the authority of the committee, and in particular, whether the committee has the authority to act on behalf of the board or simply has the authority to examine a particular issue and report back to the board with recommendations. Each committee shall be chaired by a non-executive director, and preferably independent too, who has the expertise in the relevant subject, and the majority of the members should consist of non-executive directors with at least one independent director in the committee. If a need arises, professionals from outside may be invited or hired to serve in a committee. Bank staff may also be present at the board committees for advice or special assignments on invitation.

Rules
6.1 Each bank shall have at least four board committees as set out in Rules 6.2, 6.3,

6.4 and 6.5 of this Code. Each committee shall report directly to the board. All committees shall appoint a secretary to arrange the meetings and maintain minutes, records, etc., under the supervision of the chairman of the committee. The board shall present a report of the performance on each committee, on their duties and roles at the annual general meeting.

6.2 Audit Committee

The following rules shall apply in relation to the Audit Committee.
a) The chairman of the committee shall be an independent non-executive director who possesses qualifications and experience in accountancy and/or audit.

b) All members of the committee shall be non-executive directors
c) The committee shall consider matters in connection with

(i) the appointment of the external auditor for audit services to be provided in compliance with the relevant statutes;

(ii) the Central Bank guidelines issued to auditors from time to time;

(iii) the relevant accounting standards; and

(iv) the service period, audit fee and any resignation or dismissal of the auditor; provided that the engagement of the Audit partner shall not exceed five years and the particular Audit partner is not engaged for the audit once again before the expiry of three years from the date of the completion of the previous term.

d) The committee shall review and monitor the external auditor’s independence and objectivity and the effectiveness of the audit process in accordance with applicable standards and best practices.

e) The committee shall develop and implement a policy on the engagement of an external auditor to provide non-audit services that are permitted under the relevant statutes and regulations. In doing so, the committee shall ensure that the provision by an external auditor of non-audit services does not impair the external auditor’s independence or objectivity. When assessing the external auditor’s independence or objectivity in relation to the provision of non-audit services, the committee shall consider:

i. whether the skills and experience of the audit firm make it a suitable provider of the non-audit services;

ii. whether there are safeguards in place to ensure that there is no threat to the objectivity and/or independence in the conduct of the audit resulting from the provision of such services by the external auditor; and

iii. whether the nature of the non-audit services, the related fee levels and the fee levels individually and in aggregate relative to the audit firm, pose any threat to the objectivity and/or independence of the external auditor.

f) The committee shall, before the audit commences, discuss with the external auditors the nature and scope of the audit, including

(i) an assessment of the bank’s compliance with relevant mandatory codes of corporate governance and the management’s internal controls over financial reporting;

(ii) the preparation of financial statements for external purposes in accordance with relevant accounting principles and reporting obligations; and

(iii) the co-ordination between firms where more than one audit firm is involved.

g) The committee shall review the financial information of the bank, in order to monitor the integrity of the financial statements of the bank, its annual report, accounts and quarterly reports prepared for disclosure, and the significant financial reporting judgments contained therein. In reviewing the bank’s annual report and accounts and quarterly reports before submission to the board, the committee shall focus particularly on

(i) major judgmental areas;

(ii) any changes in accounting policies and practices;

(iii) significant adjustments arising from the audit;

(iv) the going concern assumption; and

(v) the compliance with relevant accounting standards and other legal requirements.

h) The committee shall discuss issues, problems and reservations arising from the interim and final audits, and any matters the auditor may wish to discuss including those matters that may need to be discussed in the absence of key management personnel, if necessary.

i) The committee shall review the external auditor’s management letter and management’s response.

j) The committee shall take the following steps with regard to the internal audit function of the bank:

i. review the adequacy of the scope, functions and resources of the internal audit department, and satisfy itself that the department has the necessary authority to carry out its work;

ii. review the internal audit programme and results of the internal audit process and, where necessary, ensure that appropriate actions are taken on the recommendations of the internal audit department;

iii. review any appraisal or assessment of the performance of the head and senior staff members of the internal audit department;

iv. approve any appointment or termination of the head, senior staff members and outsourced service providers to the internal audit function;

v. ensure that the committee is apprised of resignations of internal audit senior staff members and outsourced service providers and provide an opportunity to the resigning senior staff members and outsourced service providers to submit reasons for resigning;

vi. ensure that the internal audit function is independent of the activities it audits and that it is performed with impartiality, proficiency and due professional care;

vii. ensure that the internal audit function reports directly to the chairman of the committee who should not be the chairman of the bank.

k) The committee shall consider any related party transactions that may arise within the bank or the bank’s group.

l) The committee shall consider the major findings of internal investigations and management’s response;

m) The committee shall evaluate the effectiveness of operations of other board committees and management level committees.

n) The chief finance officer, the head of internal audit and a representative of the external auditors may normally attend meetings.
Other board members may attend meetings upon the invitation of the committee. However, at least twice a year, the committee shall meet with the external auditors without the executive directors being present.

o) The committee shall have

(i) explicit authority to investigate into any matter within its terms of reference;

(ii) the resources which it needs to do so;

(iii) full access to information; and

(iv) authority to obtain external professional advice and to invite outsiders with relevant experience to attend, if necessary.

p) The committee shall meet regularly, with due notice of issues to be discussed and shall record its conclusions in discharging its duties and responsibilities.

q) The board shall disclose in an informative way,

(i) details of the activities of the audit committee;

(ii) the number of audit committee meetings held in the year; and

(iii) details of attendance of each individual director at such meetings.

r) Detailed minutes of the committee meetings shall be kept by a duly appointed secretary of the meeting (who may be the company secretary or the head of the internal audit function). Draft and final versions (in the event of changes to the draft) of minutes of the committee meetings may be sent to all members of the committee for their comment and records, respectively, in both cases within a reasonable time after the meeting.

s) The committee shall consider any significant or unusual items that are, or may need to be, reflected in such reports and accounts and shall give due consideration to any matters that have been raised by the bank’s accountant/finance manager, compliance officer or auditors.

t) The committee shall have the oversight of the bank’s financial reporting system and internal control procedures to:

i. review the bank’s financial controls, internal controls and risk management systems to ensure that management has discharged its duty to have an effective internal control system for all risks management; and

ii. consider any findings of major investigations of internal control matters as delegated by the board or on its own initiative and management’s response.

u) The terms of reference of the committee shall also require the committee to review arrangements by which employees of the bank may, in confidence, raise concerns about possible improprieties in financial reporting, internal control or other matters. Accordingly, the committee shall ensure that proper arrangements are in place for the fair and independent investigation of such matters and for appropriate follow-up action and to act as the key representative body for overseeing the bank’s relations with the external auditor.

6.3 Human Resources and Remuneration Committee
The following rules shall apply in relation to the Human Resources and Remuneration Committee:

a) The committee shall determine the remuneration policy (salaries, allowances, and other financial payments) relating to directors, chief executive officer and key management personnel of the bank.
b) The committee shall set goals and targets for the directors, CEO and the key management personnel.

c) The committee shall evaluate the performance of the CEO and key management personnel against the set targets and goals periodically and determine the basis for revising remuneration, benefits and other payments of performance-based incentives and obtain independent verification of the achievement of eligibility criteria relating to performance based remuneration (including the granting of share options).

6.4 Nomination Committee

The following rules shall apply in relation to the Nomination Committee:

a) The committee shall implement a procedure to select/appoint new directors and key management personnel.

b) The committee shall consider and recommend (or not recommend) the re-election of current directors, taking into account the performance and contribution made by the director concerned towards the overall discharge of the board’s responsibilities.

c) The committee shall set the criteria such as qualifications, experience and key attributes required for eligibility to be considered for appointment or promotion to the post of CEO and key management positions.

d) The committee shall ensure that directors, CEO and key management personnel are fit and proper persons to hold office as specified in criteria given in Rule 5.

e) The committee shall ensure that the directors and key management personnel have an appropriate mix of members so that the bank will operate in a safe and sound manner.

f) The committee shall consider from time to time, the requirements of additional/new expertise and the vacancies created by retiring directors and key management personnel.

6.5 Integrated Risk Management Committee
The following rules shall apply in relation to the Integrated Risk Management
Committee:

a) The committee shall consist of at least three non-executive directors, chief executive officer and key management personnel supervising broad risk categories, i.e., credit, market, liquidity, operational and strategic risks. The committee shall work with key management personnel very closely and make decisions on behalf of the board within the framework of the authority and responsibility assigned to the committee.

b) The committee shall assess all risks, i.e., credit, market, liquidity, operational and strategic risks to the bank on a monthly basis through appropriate risk indicators and management information. In the case of banks having subsidiary companies and associate companies, risk assessment and management shall be done, both on a bank basis and group basis.

c) The committee shall review the adequacy and effectiveness of all management level committees such as the credit committee and the asset-liability committee to address specific risks and to manage those risks within quantitative and qualitative risk limits as specified by the committee.

d) The committee shall take prompt corrective action to mitigate the effects of specific risks in the case such risks are at levels beyond the prudent levels decided by the committee on the basis of the bank’s policies and regulatory and supervisory requirements.

e) The committee shall meet at least quarterly to assess all aspects of risk management including updated business continuity plans.

f) The committee shall take appropriate actions against the officers responsible for failure to identify specific risks and take prompt corrective actions as recommended by the committee, and/or as directed by the Director of Bank Supervision.

g) The committee shall submit a risk assessment report within a week of each meeting to the Board seeking the board’s views, concurrence and/or specific directions.

Section 7 – Related Party Transactions
Principle
The board shall ensure that the bank shall not engage in transactions with related parties in a manner that would grant such parties “more favourable treatment” than that accorded to other constituents of the bank carrying on the same business.

Rules
7.1 The Board shall avoid any conflict of interest that may arise from any transactions, with any person, and particularly with the following categories of persons:

a). any of the bank’s subsidiary companies;
b). any of the bank’s associate companies;
c). any of the directors of the bank;
d). any of the bank’s key management personnel;
e). a close relation of any of the bank’s directors or key management personnel;

f). a shareholder owning a material interest in the bank; and
g). a concern in which any of the bank’s directors or a close relation of any of the bank’s directors or any of its material shareholders has a substantial interest.

7.2 The related party transactions that shall be covered by this Rule shall include the following:

i. the grant of any type of accommodation, as defined in the Monetary Board’s Directions on maximum amount of accommodation,

ii. The creation of any liabilities of the bank in the form of deposits, borrowings and investments,

iii. The provision of any services of a financial or non-financial nature provided to the bank or received from the bank,

iv. The creation or maintenance of reporting lines and information flows between the bank and any related parties which may lead to the sharing of potentially proprietary, confidential or otherwise sensitive information that may give benefits to such related parties (e.g. lack of internal barriers or “Chinese” walls).

7.3 In the context of this rule, “more favourable treatment” shall mean and include treatment, including the:

i. granting of total net accommodations to related parties, exceeding a prudent percentage of banks’ regulatory capital, as determined by the Monetary Board;

ii. charging a lower rate of interest than the bank’s best lending rate or paying more than the bank’s deposit rate for a comparable transaction with an unreleated comparable counterparty;

iii. providing preferential treatment, such as favourable terms, covering trade losses and waiving fees/commissions, that go beyond the terms granted in the normal course of business undertaken with unrelated parties;

iv. providing or receiving a service to or from a related-party without an evaluation procedure;

v. maintaining reporting lines and information flows that may lead to sharing potentially proprietary, confidential or otherwise sensitive information with related parties, except as required for the performance of legitimate duties and functions.

7.4 A bank shall not grant any accommodation to any of its directors or to a close relation of such director unless such accommodation is sanctioned at a meeting of its board of directors, with not less than two-thirds of the number of directors other than the director concerned, voting in favour of such accommodation. This accommodation shall be secured by such security as may from time to time be determined by the Monetary Board as well.

7.5 Where any accommodation has been granted by a bank to a person or a close relation of a person or to any concern in which the person has a substantial interest, and such person is subsequently appointed as a director of the bank, steps shall be taken by the bank to obtain the necessary security as may be approved for that purpose by the Monetary Board, within one year from the date of appointment of the person as a director. Where such security is not been provided by the period as provided above, the bank shall take steps to recover any amount due on account of any accommodation, together with interest, if any, within the period specified at the time of the grant of accommodation or at the expiry of a period of eighteen months from the date of appointment of such director, whichever is earlier. Any director who fails to comply with this rule shall be deemed to have vacated the office of director and the bank shall disclose such fact to the public. This rule, however, shall not apply to a director who at the time of the grant of the accommodation was an employee of the bank and the accommodation was granted under a scheme applicable to all employees of such bank.

7.6 A bank shall not grant any accommodation or favoured treatment relating to waiver of fees and commission to any employee or a close relation of such employee or to any concern in which the employee or close relation has a substantial interest other than on the basis of a scheme applicable to the employees of such a bank or when secured by security as may be approved by the Monetary Board in respect of accommodation granted as per Rule 7.4 above.

7.7 No accommodation granted by a bank under Rule 7.5 and 7.6 above, nor any part of such accommodation, nor any interest due thereon shall be remitted without the prior approval of the Monetary Board and any remission without such approval shall be void and of no effect.

Section 8 – Disclosures Principle
Appropriate disclosures and reporting on operations including aspects of corporate governance, consistent with accounting standards and regulatory requirements, would greatly assist and benefit market participants and other stakeholders in monitoring the safety and soundness of the bank. Disclosing key pieces of information on the capital, risk exposures, risk assessment processes, and the capital adequacy of the institution have also been clearly recognised under Pillar
Three of Basel II. The extent of disclosures should be commensurate with the size, ownership structure, economic significance, risk profile and complexity of the bank.

Accordingly, adequate and timely public disclosure of relevant information by banks facilitates enhanced market discipline and better corporate governance.

Rules
8.1 The board shall ensure that (i) annual audited financial statements and quarterly financial statements are prepared and published in line with the formats prescribed by the supervisory and regulatory authorities and applicable accounting standards and that (ii) such statements are published in the newspapers in Sinhala, Tamil and English, in an abridged form.

8.2 The board shall ensure that the following minimum disclosures are made in the Annual Report:

i. A statement to the effect that the annual audited financial statements have been prepared in line with applicable accounting standards and regulatory requirements, inclusive of specific disclosures.

ii. A report by the board on the bank’s internal control mechanism that confirms that the financial reporting has been designed to provide reasonable assurance regarding the reliability of financial reporting, and that the preparation of financial statements for external purposes has been done in accordance with relevant accounting principles and regulations.

iii. The external auditor’s certification on the effectiveness of the internal control mechanism referred to in Rule 8.2 (ii) above, in respect of any statements prepared or published after December 31, 2008.

iv. Details of directors, including names, fitness and propriety, transactions with the bank and fees/remuneration paid by the bank.

v. Details of total accommodation (as defined in the Monetary Board’s Directions on maximum amount of accommodation) granted to all related parties, net of cash collateral and investments made by such related parties in the bank’s share capital and debt instruments with a maturity of 5 years or more, as a percentage of the bank’s regulatory capital.

vi. The aggregate values of remuneration paid by the bank to its key management personnel and transactions of the bank with its key management personnel set out by broad categories such as remuneration paid, accommodation granted and deposits or investments made in the bank.

vii. The external auditor’s certification of the compliance with this corporate governance code in respect of the annual corporate governance report and the reports of board committees published after January 1, 2010.

viii. A report setting out details of the compliance with prudential requirements, regulations, laws and internal controls and measures taken to rectify any material non-compliance.

ix. A statement of the regulatory and supervisory concerns on lapses in the bank’s risk management that have been pointed out by the Director of Bank Supervision if so directed by the Monetary Board to be disclosed to the public together with the measures taken by the bank to address such concerns.

Section 9 – Transitional And Other General Provisions
9.1 Compliance with the rules as set out in this Mandatory Code of corporate governance shall commence from January 1, 2008 onwards and all banks shall fully comply with these rules by or before January 1, 2009 except in the case of certain rules which provide specific dates for compliance.

9.2 In respect of the banks that have been incorporated by certain specific statutes in Sri Lanka, the boards as specified in such statutes shall continue to function in terms of the provisions of such statutes provided they take steps to comply with all rules of this Code as are practically possible to comply.

9.3 This code shall apply to branches of foreign banks to the extent as practically possible and such branches shall submit an annual corporate governance compliance report to the Director of Bank Supervision together with the overall corporate governance compliance report of their overseas Head Office.

9.4 In the event of a conflict between any of the provisions of this Code and the Articles of Association (or Internal Rules)pertaining to any bank, the provisions of this Code shall prevail.