Need for a new version of Corporate Governance for promotion of Risk Management in banks

By P. Samarasiri, Assistant Governor, Central Bank of Sri Lanka
In response to the Directions on Corporate Governance issued to banks by the Central Bank on December 26, 2007, various views have been expressed on the nature of the corporate governance that should be in banks. Therefore, this article is published to educate the general public about the background of the corporate governance literature, the need for a specific corporate governance mechanism for banks and the nature of corporate governance introduced by the Central Bank.

1.What is Corporate Governance?
Any institution, whether it is state or private, conducts a business or economic activity which involves several categories of stakeholders such as owners/shareholders, employees, customers and general public. Therefore, it is necessary that the business of any institution should be organised and conducted in a certain management structure designed to protect the interests of its stakeholders which will mitigate its business risks and ensure its sustainability in the business. This management structure properly documented and adopted by an institution is the corporate governance. Therefore, corporate governance is about how the businesses affairs of an institution are oragnised with a good risk management mechanism in a transparent and accountable manner in the interest of both the institution and its stakeholders. Corporate governance activists, practitioners and researchers have developed certain corporate governance codes consisting of certain governance principles or certain principle-based governance rules and, therefore, certain best practices in corporate governance are available in the literature. These best practices generally relate to responsibilities, affairs and conduct of the board of directors, senior executive management and board-appointed committees and disclosure of financial position of the institution. Accordingly, the management of an institution can adopt its own corporate governance code designed following the best practices which will suit the nature of the business of the institution and stakeholders. Furthermore, various regulatory and supervisory authorities also have commenced prescribing certain corporate governance codes for the institutions falling within their purview because of the inadequacy of the institutions’ voluntary corporate governance codes, given the significance of such institutions to the general public and the economy.

Corporate governance principles had its origins in the 19th century although the term “Corporate Governance” itself came into vogue in the latter part of the 1980s. 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 in Europe. 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, i.e., the directors and managers, were safeguarding their investments and accurately reporting the financial outcome of company’s 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, the current thinking recognises a company’s obligations to the society more generally in the form of all stakeholders, and it has been this new thinking that has driven the studies and practices of good corporate governance to the levels it has reached today. Massive corporate scandals taken place in the past have been the basis for new thinking of corporate governance. Since the latter part of 2001, the very lively and often controversial debate on corporate governance became an even more turbulent debate as a result of the massive corporate scandals and failures that rocked the business world, namely, Enron and WorldCom in the US. Almost as a knee-jerk reaction, new laws, e.g., the Sarbanes – Oxley Act in the US and similar laws and/or regulations all over the world were quickly introduced in a possible attempt to prevent such scandals and failures in future, and to soothe the nervous minds of investors, both local and international.

Modern Corporate Governance Codes have extensively addressed several major governance issues. These include transactions with related-parties of the institutions such as directors, their close relations and businesses, conflicts of interest, creative accounting methods to hide adverse financial outcomes, ownership/shareholder concentration and dominance, lack of shareholders’ voice, lack of independence of auditors and strategic direction toward long-term wealth creation. In general, while related-party transactions have been at the very centre of many of Asia’s scandals, corporate scandals in the US and Europe have stemmed mostly from creative accounting which hid the true picture of financial transactions of a company. The current financial market turmoil prevailing in developed countries since August, 2007, and resulting bank failures have raised several issues relating to governance and risk management of banks and financial institutions. The failure of banks to comply with very basic rules relating to credit and liquidity risk management, usage of complex structured finance products to transfer credit risk to investors who did not understand such risks or products, resorting to unsound/risky business models, lapses in understanding and oversight of the boards of directors on complex businesses and risk management models of banks and difficulty in valuing the complex finance products to reflect their market value (fair value accounting problem) are some of them. As a result, a new wave of reform to governance in banks is now in vogue in developed countries.

2.Why a new version of corporate governance is required for banks?

This is required because of the need to conduct banking business in safe and sound manner, given the specific nature of the business and its importance to the society as highlighted below.

i).Specific business risks dependent on public confidence: The banks are the apex financial intermediaries licensed by the Monetary Board to carry on business on money in terms of the Banking Act, Monetary Law Act and other statues relating to financial and payments system. This business mainly includes raising funds through deposits and debt securities, lending and investing such funds and providing services facilitating domestic and international payments. The banks are in the business because of the public/customer confidence in banks; the belief that the banks are safe and sound to repay their liabilities on deposits and debts and to meet their financial obligations relating to other financial services such as lending and payments services without interruption. Any potential risk which may damage this public confidence will cause depositors’ run on banks as well as customers’ default on their obligations to banks which will eventually lead to liquidity crisis, insolvency and failures of even well-run banks. The literature of bank failures in many countries shows that failures of some banks may cause contagion on the banking system due to damaged public confidence.

ii).Business involving money creation: Banking system has the ability to create money through its business and this created money is the largest component of the money in circulation available for financing/facilitating economic transactions. Therefore, the business of banks is carried on a public good which is money, and banks are part and parcel of the monetary and financial system of the country. The failures of banks will adversely affect the monetary conditions and economic well-being of the public and cripple the monetary/financial system. Maintenance of monetary and financial system stability to facilitate the economic stability is the key responsibility of the Central Bank. The public undertakes transactions (such as deposits, investments and payments) through various types of money payment instruments because of their confidence that such moneys serve as the legal tender, i.e., currency, or can be converted into currency without delay. The maintenance of the public confidence in the legal tender is the responsibility of the Central Bank. Any contagion of failures of banks and large scale withdrawals of deposits will lead to liquidity crisis in the financial system because the amount of money held by the public by way of deposits with banks is significantly greater than the amount of currency in issue or currency held by banks. According to the estimate of money in circulation in terms of broad money M2, the deposits held by the public with the banking system consist of 87% whereas the currency held by banks constitute only 3% of such deposits. Therefore, maintenance of the public confidence is the key for the banking system stability.

iii).Fiduciary responsibilities of banks: Banks are the authorized agents of money to facilitate the functions of money, i.e., a medium of exchange, a unit of accounts, a deferred payments system (borrowing and lending) and a liquid store of wealth. The public conventionally treat banks as the safest places for keeping their savings. This is the general public faith/confidence in banks which is the foundation of the banking business. The majority of the public is not aware of financial analysis techniques to assess the safety and soundness of banks and direct financial gain/yield on deposits such as interest rates is not the deciding factor for them to keep deposits. The banks carry on business on such deposits whereas the amount of shareholders’ funds utilised in this business is relatively very low. Because of the special privilege given to banks to raise funds through deposits from the public, the need for shareholders’ funds for the conduct of business of banks is less and, therefore, the return to shareholders would be large. For example, nearly 72% of the banking sector assets have been funded through deposits while shareholders’ funds (capital) account for only 8% of total assets. On the other hand, average interest paid on deposits is low at 10% whereas the return (after-tax) on shareholders’ funds is 16%. If the depositors are interested only in interest gain, they could have invested their money/savings in government securities which are the safest investments but pay higher return (around 18%-19% recently) when compared with interest rates on bank deposits (around 10% weighted average recently). Therefore, the banks have fiduciary responsibilities to ensure that deposits are used safe and repayable on demand and give priority to the interests of depositors over the interests of other stakeholders.

iv).Limitations of regulation and supervision: Given the importance of the banks in the economy and economic welfare of the general public and the overall responsibilities of the governments/central banks in maintaining the monetary and financial system stability, the banking is the single industry which is subject to the highest degree of regulation and supervision globally. This regulation and supervision is to help the banks to operate their business in safe and sound manner. In this regard, a number of standard regulatory and supervisory measures are adopted. Some of them are licensing procedure to see that the banks are set up in a prudential manner not detrimental to national interests, minimum prudential limits/requirements on certain aspects of financial condition/transactions such as capital, liquidity, provision for loans, fitness and propriety of directors, preparation and disclosure of financial statements and maximum limits on loans and financial facilities granted to single customers and related-parties and investments in equity to limit the exposures to certain aspects of banking risks and periodical examinations to detect bank problems and to resolve such problems. In addition, moral suasion or the advisory capacity/capability of the Central Bank is a conventional supervisory measure to the extent of its regulatory and supervisory strength and the professional discipline of the directors and managers of the respective banks. However, the Central Bank cannot guarantee the safety and soundness of each and every bank although the general public expects the Central Bank to do so. The Central Bank can only help promote or facilitate risk management of business of banks and implement certain resolution measures for some problems of banks only to the extent of the empowerment given under the relevant legal provisions. The regulatory and supervisory role of the Central Bank will provide only an implicit safeguard to the banks to the extent of the public confidence in the safety net role of the Central Bank provided through regulation and supervision including the lender of last resort (lending to illiquid banks). Meantime, the moral hazard problem arising from the regulatory and supervisory role of the Central Bank, i.e., tendency of bank customers and bank managers to take more risks than they would take in the absence of such regulation and supervision, has to be managed prudently because such moral hazard will sow the seeds of future banking and financial crises due to excessive risk-taking by banks and customers. The Central Bank will bail out illiquid banks only in the event any failure of such banks is likely to cause contagious failures across other banks. The Central Bank cannot be the risk manager of the banks because it cannot get into the shoes of bank managers to operate the banking business. Furthermore, the Central Bank cannot control or issue rules and regulations relating to all aspects of business operations of banks because, like other businesses, banking is also a business activity that should take risks seeking profit subject to prudential norms. There can be failures of certain banks from time to time due to weak risk management and, therefore, the maintenance of safety and soundness of individual banks is the responsibility of those who organise and manage the business of those banks. However, it is the responsibility of the Central Bank to maintain the stability in the banking system and to prevent systemic bank failures. Therefore, the Central Bank will bail out only the banks that fail causing systemic risks. The Central Bank has the discretionary power in making such decisions and to differentiate between failures of banks causing systemic risks and failures of banks that raise no systemic concerns. It should be noted that regulation is a necessary form of protection for unfavourable events, but regulators should not try to protect all people from their own bad decisions. This is an example of gross over-regulation which leads to competitive disadvantage. The business sector itself is responsible for many of the regulations that it complains about because of its own failure to conduct itself appropriately.

3.What is the kind of Corporate Governance Necessary in Banks?
Two considerations should be recognized when answering this question. First, given the complexities and consequences, it is very difficult to permit bank failures. Therefore, a bank should be safe and sound at all times. Second, who should be responsible and accountable for preventing a bank failure? The external parties such as the regulators and bank auditors have a specific role to play to promote safety and soundness of banks, but they cannot be held responsible for bank failures because they do not operate or conduct or control the business and affairs of banks. They are to assist bank risk management through external advice and guidance within their powers and duties. Therefore, the board of directors which is the apex structure of the management of a bank should be primarily responsible for prevention of bank failures. Accordingly, the corporate governance in banks should be seen as the broad management framework how the boards of directors organise the business of banks with a good risk management system in transparent and accountable manner to protect the interests of stakeholders of banks. The boards of directors should accept the responsibility and accountability for the overall business and outcome of banks, undertake policy-making role, delegate the operations of banks to senior executive management led by the Chief Executive Officer to be carried on in terms of the policies determined by the boards and oversee the performance of the directors, senior executive management and operations of the banks through board-appointed committees.

The Directions on Corporate Governance for Banks issued by the Central Bank consist of 23 principles covering eight areas of governance with about 135 rules/best practices designed to implement those principles. These principles and rules relate to the 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 and disclosures and provide a broad management framework for organisation of the business of banks with prudent risk management system by the boards of directors in a responsible and accountable manner. Accordingly, the boards of directors of the respective banks can adopt a better or improved version of own corporate governance taking the principles and rules prescribed in the Directions as the base. Therefore, directors and senior executives of banks should not consider these Directions as another set of regulations that intervene in banking business. Instead, they should be viewed as the foundation for the organisation of the business of banks upon which banks could develop their own system of business management. In developing these Corporate Governance Directions, the Central Bank used its long history (more than 50 years) of regulatory and supervisory experiences in dealing with banks and global literature of concerns on risk management in banks. Furthermore, these directions are based on the Central Bank’s specific and general regulatory and supervisory responsibilities for maintaining the stability and soundness of banks and financial system. In terms of Section 46(1) of the Banking Act, in order to ensure the soundness of the banking system, the Monetary Board has been empowered to issue directions to licensed commercial banks regarding the manner in which any aspect of the business of such banks is to be conducted. Accordingly, these directions are intended to serve as the management structure how business operations are organised and conducted. Under the provisions of the Monetary Law Act, the supervision of banks has been made a duty of the Central Bank on account of specific reasons as stated by John Exter in his “Report on the Establishment of a Central Bank for Ceylon” in 1949, inter alia, as follows: “Banking is an economic activity which affects the public welfare to an unusual degree; it touches in one way or another, almost every phase of a country’s economic life. Sound banking is essential to healthy and vigorous economic development. Supervision of banks helps to protect the public against mismanagement, bank failures, and loss of confidence in the banking system. It helps to protect depositors and stock-holders against loss and frequently enables bank directors and officers to manage the affairs of their banks more wisely and intelligently.” Therefore, these directions are intended to assist the bank directors and executive officers to manage the business of banks better to protect the public confidence and interests of depositors and shareholders and, therefore, the implementation of these Directions falls within the overall supervisory responsibilities of the Central Bank. The prudent management of a bank is not a rocket science. It requires putting together skills and strategies developed by bank directors, executive officers, regulators, auditors and shareholders. The Corporate Governance Directions issued by the Central Bank provide a management framework to consolidate the skills and strategies of the above parties. Therefore, the wisest option for all those parties would be to move forward with this new corporate governance mechanism while resolving any temporary issues, if any, at its initial phase. Any parties resorting to legal action against the Central Bank will do nothing but adding some more unfavourable points about their banking discipline to the regulators, mindset. The new Corporate Governance mechanism or its specific governance principles or rules have nothing to hurt the fundamental rights of specific stakeholders of banks, but it involves in promoting fundamentals for protecting the common interests of stakeholders of banks in special, and national interests of the stability in the banking and financial system in general.

About the Author
The author holds a BA (Special) Honours Degree in Economics from the University of Colombo and a MA in Economics from University of Kansas, USA, mainly covering the subjects, Econometrics, Monetary Economics, International Finance and Macroeconomics. He is currently an Assistant Governor of the Central Bank. He has nearly 25 year career in the Central Bank in the fields of economics, statistics, bank supervision and financial stability. Prior to his current post, he held the posts of Deputy Director, Additional Director and Director of Bank Supervision. During his career in the Central Bank, he has received extensive training locally and internationally in the fields connected with macro-economic and financial sector policies. He has published a number of articles and serves as a lecturer at the Institute of Bankers of Sri Lanka.