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