Corporate Governance in the Banking System

1
Corporate Governance in the Banking System

• Third Pan-African Consultative Forum on Corporate
  Governance
• Dakar, Senegal
• 9 November 2005
• Kirk Odegard
• Secretariat, Basel Committee on Banking
  Supervision

2
Outline

• Background
• Sound corporate governance principles
• The role of supervisors
• Unique challenges
• Conclusions

3
Background
4
Background

• Organisation for Economic Co-operation and
  Development (OECD) is international
  standard-setter for corporate governance
• OECD issued corporate governance principles in
  1999
• Basel Committee issued guidance in 1999 applying
  OECD principles to banks
• Late 1990s/early 2000s corporate scandals
• OECD issued revised principles in 2004
• Basel Committee currently reviewing bank guidance

5
Why guidance for banks?

• Critical role in the economy
• Need to safeguard depositors funds
• Importance of trust and confidence
• High cost of bank failures
• Sensitivity to liquidity crises
• Access to confidential customer information
• Increasing complexity of bank activities

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Foundations of effective governance

• Foundations of effective corporate governance are
  important but may be beyond supervisory control
• Macro-economic policies
• System of business laws
• Market integrity and transparency
• Accounting standards
• Banking supervisors should be aware of
  impediments to sound corporate governance and
  take steps within their power to promote
  effective foundations

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Everyones responsibility

• Board and senior management are primarily
  responsible for effective corporate governance
• Others can help promote sound bank governance
• Shareholders
• Auditors
• Industry associations
• Governments
• Banking supervisors
• Stock exchanges and securities regulators
• Employees

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Sound corporate governance principles
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Working Group on Corporate Governance

• Established by Basel Committee to review guidance
• Incorporated elements of 2004 OECD principles
• Discussed lessons learned from corporate
  governance breakdowns
• Met with industry groups and rating agencies
• Consulted with non-BCBS supervisors
• Issued consultative paper in July 2005
• Final paper expected late 2005/early 2006

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July 2005 consultative paper

• Apply to a wide range of banks and countries
• Applicable to diverse corporate and board
  structures
• Principles, not rules
• Not as prescriptive as some national legislation
• Commensurate with bank size, complexity and risk
  profile
• Not part of Basel II
• ? May be revised based on consultation ?

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2004 vs. 1999 guidance

• Introduction of know your structure guidance
• Expanded to consider group structures
• Protection for whistleblowers
• State-owned and other non-listed banks
• More in-depth discussion of
• Conflicts of interest
• Role of the board of directors
• Audit and other control functions
• Role of banking supervisors

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Sound corporate governance principles

• Strategic objectives and corporate values
• Clear lines of responsibility and accountability
• Role of board of directors
• Oversight by senior management
• Internal and external auditors and other control
  functions
• Compensation policies and practices
• Governing in a transparent manner
• Know your structure

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Establishing strategic objectives and a set of
corporate values that are communicated throughout
the banking organisation.
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Strategic objectives and corporate values

• Should be established by the board of directors
• Corporate culture should foster ethical behaviour
• Tone at the top is important
• Standards should address corruption, self-dealing
  and other unethical or illegal behaviour
• Whistleblowers Employees should be encouraged
  to raise concerns about illegal or unethical
  practices to the board or an independent
  committee without fear of reprisal

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Potential trouble situations

• Lending to officers, employees or directors where
  allowed by national law
• Consistent with market terms or terms offered to
  all employees
• Limited to certain types of loans
• Reports should be provided to the board
• Subject to review by auditors and supervisors
• Preferential treatment to related parties
• Conflicts of interest

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Addressing conflicts of interest

• Potential conflicts of interest arising from
  activities of the bank should be
• Identified
• Prevented or appropriately managed
• Information barriers between different units
• Separate reporting lines and internal controls
• Clear, fair, accurate information to customers
• Appropriately disclosed

17
Setting and enforcing clear lines of
responsibility and accountability throughout the
organisation.
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Board and senior management

• Unclear lines of responsibility can make problems
  worse
• The board of directors should
• Define authorities and key responsibilities
• Oversee management actions
• Senior management should
• Delegate responsibilities to staff and promote
  accountability
• Be responsible to the board for the performance
  of the bank

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Accountability within banking groups

• Parent board and senior management
• Set general strategies and policies for the group
• Determining governance structure for subsidiaries
  that best contributes to effective oversight
• Be aware of risks throughout the group
• Integrate and coordinate governance structures
• Bank board and senior management
• Responsible for governance of bank
• Soundness of bank, protection of depositors,
  compliance with laws and regulations
• Intra-group outsourcing (e.g. internal audit,
  risk management) do not eliminate bank board
  oversight
• Has ultimate responsibility for corrective action
  at the bank

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Ensuring that board members are qualified for
their positions, have a clear understanding of
their role in corporate governance and are able
to exercise sound independent judgment about the
affairs of the bank.
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The board should

• Understand oversight role and duties to bank and
  shareholders
• Avoid conflicts of interest
• Have sufficient time and energy to fulfill
  responsibilities
• Maintain collective expertise as bank grows
• Implement targeted board training as necessary
• Assess the effectiveness of its own governance
  practices
• Ensure bank has an appropriate plan for executive
  succession
• Question and receive information from senior
  management
• Provide sound and objective advice
• Do not participate in day-to-day management
• Exercise due diligence in hiring external
  auditors

22
Independent directors

• Board should have adequate number of independent
  directors
• Independence ability to exercise objective
  judgment
• Helpful if not members of bank management
• Especially important in certain areas
• Ensuring integrity of reporting
• Review of related-party transactions
• Nomination of board members and key executives
• Board and key executive compensation

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Ensuring that there is appropriate oversight by
senior management.
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Senior management responsibilities

• Should have necessary skills to manage business
  and exercise appropriate control
• Oversee line managers consistent with board
  policies
• Critical role Establishing system of internal
  controls
• Situations to avoid
• Inappropriate involvement in business line
  decisions
• Managing areas without skills or knowledge
• Inability to control star employees

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Effectively utilising the work conducted by
internal and external auditors, as well as other
control functions, in recognition of their
critical contribution to sound corporate
governance.
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Auditors and other control functions

• Should be
• Independent
• Competent
• Qualified
• Identify problems in risk management internal
  control
• Ensure financial statements are accurate

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Enhancing audit control effectiveness

• Recognise importance and promote throughout bank
• Enhance independence (e.g., limit non-audit
  services)
• Auditors have duties to bank and its stakeholders
• Consider rotation of audit firm or lead audit
  partner
• Utilise audit findings and require timely
  correction
• Report to the board or audit committee
• External auditors review internal controls
• Independent directors meet in the absence of bank
  management with external auditor and heads of
  internal audit, compliance, legal functions

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Ensuring that compensation policies and practices
are consistent with the banks ethical values,
objectives, strategy and control environment.
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Board and key executive compensation

• Compensation should be consistent with
• Long-term business objectives and strategy
• Corporate culture
• Control environment
• Should not overly depend on short-term
  performance
• Board (or independent committee) should approve
  compensation
• Policies re trading bank stock and
  granting/re-pricing stock options

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Conducting corporate governance in a transparent
manner.
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Transparent governance

• Necessary for shareholders, other stakeholders
  and market participants to monitor and hold
  accountable the board and senior management
• Need information on corporate structure and
  objectives
• Complex cross-shareholdings can impede
  transparency
• At a minimum, all banks should make disclosures
  to supervisors

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What should be disclosed?

• Disclosure on public website or in annual report
• Board and senior management structure
• Organisational structure (including ownership)
• Incentive structure of the bank
• Code of business conduct and/or ethics
• Related-party transactions
• Full annual financial statement with supporting
  notes and schedules

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Maintaining an understanding of the banks
operational structure, including operating in
jurisdictions, or through structures, that impede
transparency (i.e. know your structure).
34
Operational structure

• Some bank operations may lack or impair
  transparency
• Particular jurisdictions (e.g. some offshore
  centres)
• Complex structures (e.g. special purpose vehicles
  or corporate trusts)
• Banks may provide services or establish opaque
  structures for clients
• Often legitimate and appropriate business purposes

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Supervisory concerns

• The use or sale of opaque structures/products
  may
• Pose potentially significant financial, legal and
  reputational risks
• Impede board and senior management oversight
• Hinder effective banking supervision
• Risks should be appropriately assessed and managed

36
Risk management expectations

• Clear policies and procedures should be in place
• Approval for use and sale
• Identify and manage all material risks
• Need for such activities should be regularly
  assessed
• Corporate governance expectations should be
  established for all relevant entities
• Activities should be subject to enhanced audit
  procedures and internal control reviews
• Assess compliance with applicable laws,
  regulations and internal policies and procedures

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The role of supervisors
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Supervisory role

• Poor corporate governance practices can be a
  cause or a symptom of larger problems
• Banking supervisors should
• Promote strong corporate governance
• Determine whether the bank has sound corporate
  governance policies and practices
• Hold the board of directors and senior management
  accountable for governance and internal control
  weaknesses
• Be attentive to warning signs of deterioration in
  management
• Consider issuing supervisory guidance for
  governance

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Supervisory questions

• Does the board exercise effective oversight?
• Are controls to detect and mitigate conflicts of
  interest adequate?
• Are internal controls properly implemented (as
  opposed to being written down but not
  operational)?
• Do internal and external audit functions conduct
  independent and effective reviews?
• Are major shareholders, directors and managers
  fit and proper?
• Will an individuals skills and experience
  contribute to bank safety and soundness?
• Does criminal or regulatory record make a person
  unfit?
• Is a group structure managed in such a way as to
  negatively impact management of the bank?

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Unique challenges
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Controlling shareholders

• For example, family-owned or other non-listed
  banks
• Controlling shareholders can be a valuable
  resource
• Unique governance challenge because of influence
• There should be sufficient checks and balances on
  inappropriate activities or influences
• The board and its directors have responsibility
  to the company and all of its shareholders
• Supervisors should be able to assess fitness
  propriety of bank owners

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State-owned banks

• OECD has issued guidance for state-owned
  enterprises
• General principles should be applied to
  state-owned banks
• Ownership and supervision functions should be
  fully separated
• Government should not be involved in day-to-day
  management
• Board independence from political influence
  should be respected
• Objectives of state ownership and states
  ownership policy should be disclosed

43
Two-tier boards

• Some countries adopt a two-tier board of
  directors (e.g. management board and supervisory
  board)
• Basel Committee recognises that both one-tier and
  two-tier boards may be appropriate
• Two-tier boards may be structured differently
  across jurisdictions, so no specific guidance
• Whichever structure is used, principles of sound
  corporate governance should be in place

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Conclusions
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Wrapping up

• Banks have a unique role in the economy, so
  targeted corporate governance guidance is
  appropriate
• Key elements
• Board of directors oversight
• Senior management internal controls
• Supervisors promote and assess sound governance
• Actual practice is just as important as written
  policies and procedures

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• Questions or Comments?
• Kirk Odegard
• Member of Secretariat
• Basel Committee on Banking Supervision
• Bank for International Settlements
• kirk.odegard_at_bis.org