The 2006 BCBS Guidelines on Enhancing the Corporate Governance for Banking Organizations

May 29, 2006 Karachi, Pakistan

Presentation Outline

1.

Why corporate governance matters in general and to banks in particular What is special about bank vs. corporate governance An introduction to the Basel Committees guidance on enhancing corporate governance for banking organizations

2.

3.

4.

Concluding remarks

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Why corporate governance matters to corporations in general and banks in particular

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Defining the Starting Point: What is Corporate Governance for Banks

System by which corporations are directed & controlled The manner in which the business and affairs are governed by boards of directors and senior management, which affects how they: Set corporate objectives Operate the banks business on a day-to-day basis Meet the obligation of accountability to their shareholders and take into account the interests of other stakeholders Align corporate activities and behavior with the expectation that banks will operate in a safe and sound manner, and in compliance with applicable laws and regulations Protect the interests of depositors

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Corporate Governance Matters for Banks Themselves, and Economic Development

Corporate governance: 1. Increases access to finance

Investment, growth, employment opportunities

2. Lowers cost of capital and improves valuation

Investment & growth opportunities

3. Improves operational performance

Better allocation of resources & better decision-making creates wealth

4. Builds/restores a banks reputation

Build trust between banks and its stakeholders, including shareholder, investors, regulator, depositors, employees key in weak external environment

5. Less and better managed risk

Fewer defaults, fewer financial crises brings economic stability

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In Particular Because of the Central Role Banks Play in the Economy Well-governed banks will play a positive role in the economy
Mobilizing and allocating societys savings Providing financing to firms (in particular in most developing countries w/i deep equity markets)

While poorly-governed banks can lead to disastrous outcomes

Bank crisis at Banco Ambrosiano (1972), Metallgesellschaft (1993), Barings Group (1995), Sumitomo (1996), Merrill Lynch (2001), Allied Irish Banks (2002), Freddie Mac (2003) Asia and Russia financial crisis

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Corporate Governance Also Matters to the Firms and Households Banks Lend to
Corporate governance affects

Banks valuation & cost of capital

Bank performance, i.e. costs of financial intermediation

Corporate governance of banks thus affects the cost of capital of the firms and households they lend to

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Why Corporate Governance is Different for Banks Then for Firms (To a Degree)

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Most banks are (publicly or privately held) companies themselves!

And so: Banks also have shareholders, directors and managers, with the same agency conflicts and costs Corporate governance issues relevant to companies are thus also relevant to banks, e.g.:
A vigilant and independent board, The protection of (minority) shareholder rights and Appropriate disclosure and transparency

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Yet Differences in the External Environmentand Hence Corporate GovernanceExist

Varying Externalities lead to important differences in economic behavior! Heavier regulation,
- Activity restrictions) - Prudential requirements (reserves, provisions)

Macroeconomic

Global Market Trends: Globalization, consolidation, new technology Key economic role played by banks: Managing savings, providing financing Financial Structure: High debt/equity Transparency: Opaque, culture of secrecy Insider Role: Power role, conflict of Interests Risk Management: More complex that for firms; internal audit more difficult Employment & Incentives: Limited mobility Shareholders: More dispersed due to govt. restrictions Regulator and supervisor Depositor Creditor General public

Public safety net less mkt. discipline

Microeconomic

Conflicts of interests more prevalent; harder to assess performance & risk higher chance misuse (tunneling)

Additional Stakeholders

Less incentive to monitor directors and management govt. plays more active role

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Studies and Practice on Bank Corporate Governance Have a Simple, Yet Telling Story
Banks are more difficult to monitor
Moodys and S&P disagreed on only 15% of all firm bond issues, but disagreed on 34% of all financial bond issues

Banks are more vulnerable

Recessions increases spreads on all bond issues, but increases spreads on riskier banks more than for firms Partly result of a flight to safety, but also greater vulnerability of banks compared to non-financial firms

In practice, banks with weak corporate governance have failed more often
Accrued deposit insurance, good summary measure of riskiness of banks, higher for weaker CG State-owned banks enjoy even larger public subsidy, that is often misused: poor allocation, large NPLs, e.g., Indonesia, South Korea, France, Thailand, Mexico, Russia Fiscal costs of government support up to 50% of GDP, large output losses from financial crises

Countries with weaker corporate governance and poorer institutions see more crises

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What Does This Imply for Bank Corporate Governance and Regulation?
Two approaches to corporate governance related laws & regulations
1. Monitor banks through laws and regulations, based on international best practices (Basel I & II) 2. Empower banks through information and best practices, e.g. through a code based on the OECD Principles and Basel Committee Guidelines

Approaches not mutually exclusive: But what is best mix of private market and government oversight of banks? Banks certainly can preempt regulatory (re)action by implementing good corporate governance

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An Introduction to the Basel Committees Guidance on Enhancing the Corporate Governance of Banks

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Background Information on the Basel Committee Guidance

Applies to a wide range of banks and countries
Including SOEs and FOEs; OECD & emerging countries

Applicable to diverse corporate and board structures Principles, not rules Not part of Basel II; applicable regardless Not intended to add new layer of regulation or to replace national codes Purpose: To assist banks to enhance their corporate governance frameworks and supervisors in assessing the quality of those frameworks
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I. Ensuring For Good Board Practices

Are the banks board members qualified?
Right mix-of-skills in banking, finance & risk mgmt., cg, etc,. Are the right election procedures in place Can directors commit sufficient time and energy

Do they have a clear understanding of their role?

Setting overall strategy and managerial oversight, not day-to-day Fiduciary duties of care and loyalty To act in the interest of the company and all shareholders Fit and proper tests; succession planning

Are the able to exercise independent judgment

Free from any conflicts of interest, and thus able to monitor financial reporting, remuneration and nomination procedures

Right board size, leadership and procedures in place?

Do key committees exist: audit, risk, cg/nomination, remuneration Ability to obtain material information in timely manner Do tough, but quality discussions take place
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II. Establishing Strategic Objectives and a set of Corporate Values

Board should establish strategic objectives and ethical standards, conditio sine quo non to bank activities Interests of stakeholders should be taken into account Best if explicit rather than implicit, but corporate culture and tone at the top turnkey (practice vs. theory) Whistleblowing procedures should be implemented Key issues to address: corruption & bribery, self-dealing, unethical behavior and conflicts of interest Communicated throughout bank Board is responsible for proper implementation of corporate governance, incl. internal/related party lending
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III. Setting and Enforcing Clear Lines of Responsibility and Accountability

Clearly define authorities and responsibilities between shareholders, the board & management Also important in group structures:
Board at group level responsible for overall strategy, oversight of subsidiaries, and risk/internal control structure of entire group Board at subsidiary level retains cg responsibilities for subsidiary itself Key issue: Open & transparent intra-group policies to deal with conflicts of interest among entities w/i group
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IV. Ensuring For Appropriate Oversight by Senior Management

Senior managers should establish an effective system of internal control E.g. Four eyes principles for key decision Approved and periodically reviewed by the board

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V. The Importance of Internal & External Controls and Audit to Sound Corporate Governance
The external audit
Importance of independent, external auditor is communicated throughout bank

The internal audit

Independent

Internal controls
Management letter issued Monitors compliance with corporate governance rules, regulations, codes and policies Direct reporting to the boards audit committee Independence must be real: no/limited non-audit services At minimum, rotation of external audit partner 19 of 26 Report to boards audit committee

VI. Ensuring that Compensation is In-Line with a Banks Values, Strategy & Control Environment
Link board and management remuneration to longterm business strategy of bank
E.g. LT performance targets vs. st-volume or profitability Options should only be granted under appropriate terms (time limits to hold/trade) and shareholder approval

Differentiate between executive & non-executive pay

Both should enable the bank to attract & retain top talent, but former has stronger linked to performance while latter to responsibility and time commitment

Independent remuneration committee sets remuneration Board discusses and validate shareholders (ideally) approve final package

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VII. Conducting Corporate Governance in a Transparent Manner

Shareholders & other stakeholders can only effectively monitor directors & managers if bank is transparent!
Particularly important for banks objectives and structure

Material and timely disclosure is key, notably on:

Full set of financials (incl. notes) Board and senior mgmt. structures Basic organizational structure Incentive structures (remuneration) Bank-level corporate governance code and code of ethics Nature and extent of transactions with affiliates and related parties

Disclose in annual report and publish on website

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VIII. Know Your Structure

Establishing off-shore SPVsalthough possibly serving legitimate business needspose real oversight and reputational risks
Require close attention by board Risks need to be carefully analyses Purpose, structure, volume of SPVs needs to be defined and disclosed Clear policies for such structures need to be developed Audit committee needs to pay close attention Internal and external audit and controls need to include these structures

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The Role of the Supervisor Supervisors should

Provide guidance to banks on sound & proactive corporate governance Consider corporate governance as one element of depositor protection Determine whether banks have adopted & effectively implemented sound corporate governance policies & practices Assess the quality of banks audit and control functions Evaluate the effects of the banks group structure Bring to the board of directors and managements attention problems that they detect through their supervisory efforts

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The Role of Stakeholders

Shareholders by exercising shareholder rights Depositors and other customers by avoiding business with unsound banks

Auditors through an established and qualified audit profession, audit standards and communication to boards and supervisors
Banking industry associations initiatives re. best practices and training Professional risk advisory firms and consultancies assisting banks in implementing sound corporate governance practices Governments through laws, regulations, enforcement and an effective judicial framework Credit rating agencies through review and assessment of the impact of corporate governance practices on a banks risk profile Securities regulators, stock exchanges and other self-regulatory organizations through disclosure and listing requirements Employees through communication of concerns regarding illegal or unethical practices or other corporate governance weaknesses.
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And One Final Remarkable Feature

Know the corporate governance of your client

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Thank You for Your Attention

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