The role of good governance, disclosure and transparency in banking stability

1. The role of good governance, disclosure and transparency in banking stability David Carse Deputy Chief Executive Hong Kong Monetary Authority 22 February 2001

2. Introduction • Two important trends in banking regulation and supervision have become evident in recent years • stress on the key role of the directors and senior management in ensuring that banks are prudently managed • the role of disclosure and market discipline in promoting the accountability of directors/management and in discouraging excessive risk-taking • These trends are the subject of this presentation

3. The role of bad corporate governance in the Asian crisis • Weak corporate governance in Asian banks was one of the key factors in the Asian crisis • many banks were controlled by owner-managers and the board of directors played little role • banks were often parts of wider conglomerates and were used to fund other parts of the group or the owners (connected lending) • management was not professional and lacked self-responsibility • growth was more important than return on capital • risk management was poor

4. The situation in Hong Kong • Corporate governance of Hong Kong banks is relatively good by regional standards as has been shown by their ability to survive the Asian crisis intact • However, there were some weaknesses in the performance of the boards of a few local banks during the Asian crisis • in these cases, the board of directors failed to play a proper leadership role • To address this situation, the HKMA issued a guideline on corporate governance in locally incorporated authorized institutions in May 2000

5. The role of the HKMA • Promotion of good corporate governance is part of the supervisory responsibilities of the HKMA • Corporate governance is particularly important for banks because of the risks they take on and because they safeguard other people’s money • Directors need to ensure that the risks in banks are properly managed, and under the Hong Kong Banking Ordinance they have a specific legal responsibility to do so • This does not mean that the directors should themselves formulate policies for managing risk, but they should certainly approve such policies

6. Contents of the HKMA Guideline • Major responsibilities of the board • ensure competent management • approve objectives, strategies and business plans • ensure that the bank’s operations are conducted prudently and within the framework of laws and board policies • ensure that the bank’s affairs are conducted with a high degree of integrity • Legal obligations of directors • The use of auditors, including internal audit • Specific requirements

7. Specific Requirements (1) • The board should ensure that the bank establishes policies, procedures and controls to manage the various types of risk with which it is faced • 8 types of risk specified by HKMA (i.e. credit, interest rate, market, liquidity, operational, reputation, legal and strategic risk) • board should approve relevant policies to manage these risks while senior management should put them into effect • policies should not exist merely for form’s sake (e.g. to satisfy the regulator), but should dictate how the bank is actually run in practice

8. Specific Requirements (2) • The board should ensure that the bank fully understands the provisions of section 83 of the Banking Ordinance on connected lending and establishes a policy on such lending • section 83 of the Ordinance limits the unsecured advances of banks to connected parties (e.g. directors and their relatives) • board should ensure that the bank fully understands its legal obligations and establishes a policy on connected lending according to the minimum standards specified in the Guideline

9. Specific Requirements (3) • The board should ensure that it receives the management letter from the external auditor without undue delay, together with the comments of management • management letter should normally be received within 4 months from the financial year-end • board and/or audit committee should ensure appropriate action is taken to address any weaknesses identified in the management letter • copy of the management letter should be given to the HKMA

10. Specific Requirements (4) • The board should maintain appropriate checks and balances against the influence of management and/or shareholder controllers, in order to ensure that decisions are taken with the bank’s best interests in mind. • board should have at least 3 independent non-executive directors to provide the necessary checks and balances and bring in outside experience • banks should notify the names of their independent directors to the HKMA • HKMA may require additional independent directors to be appointed

11. Specific Requirements (5) • The board should establish an audit committee with written terms of reference specifying its authorities and duties • audit committee should be made up of non-executive directors, the majority of whom should be independent • Board meetings of a bank should be held preferably on a monthly basis but in any event no less than once every quarter • banks should keep full minutes of board meetings • HKMA will require banks to provide it with a record of the number of board meetings held each year

12. Specific Requirements (6) • Individual directors should attend at least half of board meetings held in each financial year and all meetings where major issues are to be discussed • participation of directors in board meetings can be facilitated by video or telephone conferencing • HKMA will monitor the attendance records of individual directors • The HKMA will meet the full board of directors of each bank every year. • HKMA’s intention is not to participate in board meetings but to strengthen communication between the HKMA and the banks at the highest level

13. How can good corporate governance of banks be achieved? • Main responsibility rests with shareholders, directors and management • Regulation and supervision also play a role • Both of the above need to be supplemented by adequate public disclosure • This facilitates private sector oversight of the risk-taking and financial condition of banks • disclosure makes directors and senior managers more accountable to the various stakeholders • increases the number of “watchful eyes”, thus reinforcing supervisory efforts

14. What should banks disclose? (1) • Financial performance (breakdown of income and expense etc) • Financial position (breakdown of on and off-balance sheet items, including capital position and liquid assets) • Risk management strategies and practices • Risk exposures (including quantitative and qualitative information on credit, market, liquidity, operational, legal and other risks)

15. What should banks disclose? (2) • Accounting policies • Basic business, management and corporate governance information (including business strategies, group structure, board and management structure, remuneration policies etc)

16. Disclosure and transparency • Disclosure doesn’t necessarily achieve transparency • To achieve transparency, disclosure must enable users to properly assess the bank’s risk profile, financial condition and performance, business activities etc • Therefore disclosure must be • comprehensive • relevant and timely • reliable • comparable • material

17. The benefits of disclosure (1) • Well managed banks should benefit, e.g. from improved access to capital markets and more secure funding at a lower cost • Enable a more efficient allocation of capital between banks by helping shareholders to more accurately assess and compare the risk and return prospects of individual banks • Enable a wider set of shareholders to participate effectively in the governance of the banks and make the corporate governance process more transparent

18. The benefits of disclosure (2) • Enable depositors and other creditors to better decide which banks they should place their money with and to curb excessive risk-taking • Reduced risk of market disruptions - ongoing disclosure should make market participants less likely to overreact to negative information • Strengthened incentives for banks to behave in a prudent and efficient manner

19. The benefits of disclosure (3) • Reduction in systemic risk through better ability to distinguish higher risk banks from those that are fundamentally safe and sound • should reduce the risk of contagion • Reinforce supervisory guidance by making banks disclose when they are non-compliant • Reduce moral hazard faced by supervisors

20. How can disclosure be made effective? • Two broad goals in designing effective disclosure standards • how to achieve transparency • how to achieve market discipline

21. The problems of achieving transparency • The financial strength and riskiness of banks are inherently difficult to evaluate • problem of how to value loan portfolios • how to communicate meaningfully the risk appetite and quality of risk management of a bank • difficulty of comparability of financial information o/a differences in accounting standards, supervisory guidelines, interpretation, enforcement • limits on disclosure of customer information and proprietary information, e.g. on risk management techniques and strategies • problem of keeping up to date with rapid changes in banks’ risk profiles

22. The problems of achieving market discipline • Market participants may not respond to information in a way that promotes financial stability • publicly disclosed information may not be regarded as sufficiently credible • participants may rely on official safety nets for protection • retail depositors may be unable to monitor a bank’s condition via public disclosure • shareholders may fail to discipline management • management may lack incentives to behave prudently

23. Necessary conditions for disclosure to be effective • Effective disclosure depends on the infrastructure within which banks operate • the nature and adequacy of corporate law • the adequacy of accounting standards and auditing requirements • the expertise and integrity of the auditing profession • the adequacy of the financial news media and market commentators and analysts

24. Potential drawbacks of public disclosure • Cost of producing and providing information • Market may react more harshly than desirable when it becomes aware that a bank is weakened • potential that bank may fail from liquidity problems even if it is solvent • other banks may be affected through contagion, particularly in times of financial stress • However,contagion risk should be reduced in an environment of adequate ongoing public disclosure • Also, the market incentives provided by disclosure should help to correct bank-level problems at an early stage

25. The role of supervisors in improving transparency (1) • Supervisors should try to promote comparability, relevance, reliability and timeliness of information disclosed • issue disclosure standards and guidelines or at least influence the debate on these • Encourage the use of supervisory definitions and reporting classifications for public disclosure purposes to facilitate comparison of data • Mediate if banks fail to agree privately on standards in order to speed up the process of disclosure convergence

26. The role of supervisors in improving transparency (2) • Publication of aggregate information received from banks • Difficult to go beyond this to disclose information on individual banks, e.g. supervisory ratings • would conflict with the supervisors’ role to maintain banking stability and make it more difficult to resolve individual banks’ problems • could make supervisors more reluctant to make independent judgments about banks if these were to be made public • could make it more difficult to obtain confidential information from banks

27. The role of supervisors in improving transparency (3) • Supervisors can help to ensure compliance with disclosure standards through • regular review of what banks disclose • taking action against banks that provide insufficient or misleading disclosure • ensuring that banks have effective accounting standards and practices • maintaining close liaison with internal and external auditors

28. The Hong Kong experience of bank disclosure (1) • Prior to 1992, banks in HK maintained inner reserves and disclosed little balance sheet or P/L information, e.g. • one line P/L account: “net profit after tax and transfers to inner reserves” • Rationale was to smooth out large fluctuations in profits and thereby help maintain public confidence in the banking system • This was a vital issue in the run-up to the Handover in 1997

29. The Hong Kong experience of bank disclosure (2) • While the stability objective was valid, pressure for change became irresistible • HSBC disclosed inner reserves in 1992 accounts following merger with Midland Bank • lack of disclosure seen as incompatible with HK’s position as an international financial centre • criticism from rating agencies and analysts • SFC/SEHK concern about listed banks • HKMA persuaded other local banks to disclose transfers to inner reserves in 1994 accounts and accumulated amount of inner reserves in 1995 accounts

30. The Hong Kong experience of bank disclosure (3) • The market reaction to the disclosure of inner reserves was uneventful • Amount of disclosure (e.g. of non-performing loans) has been increased each year through annual HKMA Guidelines • Experience has been positive and stabilising • image of HK banks has improved • public and media seem to accept that bank profits will fluctuate • announcement of losses by a few banks during the Asian crisis was absorbed without incident

31. The Hong Kong experience of bank disclosure (4) • Disclosure by banks in HK has been rated the best in the Region (e.g. by the IMF) • But banks here cannot afford to relax • other countries in the Region are catching up and even moving ahead in some respects (e.g. Thai banks now publish NPLs on a monthly basis) • the international standards for disclosure are being raised all the time • The New Capital Accord just announced by the Basel Committee on Banking Supervision is a prime example of this

32. The New Basel Capital Accord • Will replace the present 1988 Accord in 2004 • More risk-sensitive framework for calculating capital requirements • More emphasis on banks’ internal methodologies • More options for banks • Disclosure and market discipline play a central role

33. Structure of the New Accord • Three pillars • First Pillar - minimum capital requirement • Second Pillar - supervisory review process • Third Pillar - market discipline • All three pillars are intended to be mutually reinforcing

34. The Third Pillar • This aims to bolster market discipline by ensuring that market participants can better understand banks’ risk positions and the adequacy of their capital • disclosure mainly directed at wholesale counterparties • The greater use of internal methodologies for calculating capital requirements has increased the need for disclosure • ensure that these are exposed to public scrutiny • knowledge of methodologies used by different institutions will make comparability easier

35. Disclosure policy statement • Disclosure should be embedded in the management process and given sufficient status “Banks should have a formal disclosure policy approved by the board of directors. This policy should describe the bank’s objective and strategy for the public disclosure of information on its financial condition and performance. In addition, banks should implement a process for assessing the appropriateness of their disclosure, including the frequency of disclosure.”

36. Other aspects of the Third Pillar (1) • Distinction between core and supplementary information • former should be disclosed by all banks • latter should also be disclosed, by sophisticated internationally active banks at least • Supervisors should enforce disclosure • disallow use of internal methodologies or lower risk weights if relevant disclosure not made

37. Other aspects of the Third Pillar (2) • Frequency of disclosure should generally be half-yearly, though in some cases may need to be quarterly or even as soon as possible after material events • Basel Committee has provided templates for disclosure of the various items to encourage comparability

38. Four main areas of disclosure (1) • Scope of application of the New Accord • which corporate entities within a banking group are included in the calculation of capital adequacy and which are left out • Structure of capital • nature, components and features of capital, e.g. breakdown of Tier 1 and Tier 2 capital, accounting policies and the terms and conditions of capital instruments

39. Four main areas of disclosure (2) • Risk exposures and assessment • amount and breakdown of various types of risks and explanation of how these risks are managed, details of use of external rating agencies or internal ratings for measuring credit risk, details of use of collateral or guarantees for mitigating credit risk • Capital adequacy • capital requirements for the various types of risk and the percentage of capital to total capital requirements

40. Initial market reactions • Banks generally accept the principle of greater disclosure as the price for greater management discretion in setting capital requirements • But some concerns, e.g. • cost of compliance • need to focus on quality rather than just quantity • potential loss of proprietary information • lack of a level playing field with non-bank competitors • possible misunderstanding by bank analysts • Industry will be working on counter-proposals during the consultation period

41. Conclusions • Sound banks depend on three disciplines • internal discipline of the bank itself • external discipline of the supervisor • external discipline of the market • The latter requires an adequate level of public disclosure • But more information is not always better • Disclosure doesn’t always achieve transparency • Quality counts and comparability is essential