May 29, 2006 – Karachi, Pakistan

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The 2006 BCBS Guidelines on Enhancing the
Corporate Governance for Banking Organizations
May 29, 2006 Karachi, Pakistan
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Presentation Outline

• 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
• 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
• Increases access to finance
• Investment, growth, employment opportunities
• Lowers cost of capital and improves valuation
• Investment growth opportunities
• Improves operational performance
• Better allocation of resources better
  decision-making creates wealth
• Builds/restores a banks reputation
• Build trust between banks and its stakeholders,
  including shareholder, investors, regulator,
  depositors, employees key in weak external
  environment
• 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

• 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
lead to important differences
Varying Externalities
in economic behavior!
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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 SP 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
• Monitor banks through laws and regulations, based
  on international best practices (Basel I II)
• 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 theCorporate 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
Report to boards audit committee
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 externalaudit partner
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VI. Ensuring that Compensation is In-Line with a
Banks Values, Strategy Control Environment

• Link board and management remuneration to
  long-term 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