Improving the Governance of India’s Public Sector Banks

1. Improving the Governance of India’s Public Sector Banks Presentation by : Dr. R. H. Patil Chairman The Clearing Corporation Of India Ltd. At India’s Financial Sector Conference GOA, November 1 - 2, 2002

2. Financial Fragility In Asia Japan and China are interesting cases Chinese situation more serious than Japanese -ownership matters China’s banks insolvent. Japan NPA’s at $ 1.25 trillion or 8% of GDP 30%of advances ($518bn) Indian scene less alarming because of high SLR/CRR as also financial sector smaller in relation to GDP Post deregulation experience mixed : Successes and Failure in both sets 2

3. Special Features • Corporate Governance in Financial Sector poses special problems. • Unlike the real sector, the resources can get tainted very fast and with less visible signs. • Vulnerability because entities are highly leveraged. • Bulk of the literature on CG discusses the issues from non financial sector perspectives • Even BIS skirts the issues of ownership and lays emphasis on risk management etc • Possibly because it accepts the OECD Principles • Unitary vs two – tiered board structure • RISKS that FINANCE SECTORS OFTEN BECOMES PONZI SCHEME SECTOR

4. Ownership&Management • A priori ownership should not matter. • Experience shows high vulnerability irrespective of ownership character • Critical factors are Quality of CG and transparency • Quality of CG is crucially dependent on quality of board. • Conflicts of interest in private sector ownership difficult to avoid. It is not only taking loans to group companies that is the risk. But business strategies may also be biased against certain industries/sector/business groups

5. Constitution of PSB Boards • The BR Act & the Bank Nationalisation Act Determine Composition of Boards of PSB’s • Not Less Than 51% of the Board Members having Practical Experience in Accountancy, Agriculture, Rural Economy, Banking, Co-operation, Economics, Finance, Law, SSI, etc. • Of these not less than 2 with practical experience in Agriculture, Rural economy, Co-operation, & SSI • Shareholder Directors in PSB’s in proportion to Issued Capital, but with Limit of 6 Nominees • Selection Process of shareholder directors is Akin to That of Family Controlled Companies • Boards of BSBs & SBI constituted by GoI in Consultation With RBI • CMD & EDs Appointed by the GoI

6. Public Sector Banks • Layered, hierarchical, principal-agent structure. • Civil servants often act as agents & Labour unions step in to establish, “proprietary right”. • Boards should be empowered with Government transparently issuing guidelines, directives etc • Government should shift from controlling management actions to monitoring performance results. • Adopt arms-length approach and give full board autonomy

7. REASONS FOR POOR PERFORMANCE OF BANKS • As per the Banking Companies Act Powers of “General Superintendence, Direction and Management” vest with the Board • But There in No Board Accountability Since Board not Empowered De Facto • Invariably Board Dominated by the GoI & the RBI Directors who are more Equal • Govt Often Going Beyond the Act viz., Policy Matters Involving Public Interest (Sec 8). Govt Controls even Selection & Promotion of Senor-level PSB staff • Govt Has Total Control Over Banks & Boards Play Invariably a Convenient/Marginal Role • Day-to-day Control Saps Initiative and Entrepreneurshipon the Part of Management & the Board

8. INADEQUACIES IN APPOINTMENT OF BOARD MEMBERS • Necessary to Effect Amendments to Statues to Improve CG. Until then • Introduce Desirable & Doable Practices for Enhancing CG • Have Three Full-time Directors Since Banking Is a Complex Business • Chairman Should Not also be MD—Hence Separate the Posts of Chairman & MD • Boards Should Have Nomination Committees to Recommend Induction of Independent Directors • The Appointment Process should become more Professional Rather Than Political • Board should have Supervisory Committee, Remuneration Committee, Audit Committee, Nomination Committee, Shareholder Redressal Committee & Risk Management Committee • Scrap Sec 20 of the BR Act to enable professionals to Join Boards

9. BOARDS BE NEED BASED RATHER THAN REGULATION BASED • Banking More Complex & Knowledge-based Needing Board Members Who Are More Contemporarily Professional, Technically & Specially Qualified • Blend of Historical Skill Set & New Skills Set (Technology, Risk Mgt, Treasury Operations, Strategic Planning, etc.) • Ganguli Cmt recommends Panel of Directors Should Be Prepared by RBI, while Patil Adv Grp Wants a Group of Eminent Persons to Do the Job • Boards Should Be Distanced from the Mof-GoI so that Boards are Truly in Charge of Governance • Both RBI & GoI Should not Appoint their Officials on the Boards of Banks Since it has Created Asymmetric Distribution in Power Among Board Members • Improve Board Remuneration to Contemporary Standards to attract Qualified & Competent Persons

10. Constitution of Board • Set up Independent Selection Board ( ISB ) of eminent persons – more like UPSC • Decisions of ISB should be final and Government only to issue appointment of CEO’s. • ISB to prepare a panel for other board positions • Initially Constitute Boards and later Appointments Committees of the boards to fill subsequent vacancies. • ISB to supervise subsequent process and adopt policy of management by exception

11. Regulatory Clarity • Government to give up multiple roles – owner , manager, quasi-regulator and sometimes super regulator. • Introduce equality among board members. • Audit Committee to concentrate on audit of management policies, internal control mechanism, risk management policies and implementation effectiveness. • RBI should remain only as regulator and not appoint the nominees on the boards. • Do away with the system of directors representing sectional interests.

12. The board should fulfil certain key functions, including: • Reviewing and guiding corporate strategy, major plans of action, risk policy annual budgets and business plans; setting performance criteria/goals • Selecting, compensating, monitoring and, when necessary, replacing key executives and overseeing succession planning. • Reviewing key executive and board remuneration and ensuring a formal and transparent board nomination process.

13. Monitoring Financial Activities • Monitoring and managing potential conflicts of interest of management, board members and share holder, including misuse of corporate assets and abuse in related party transactions. • Ensuring the integrity of the corporation’s accounting and financial reporting systems, including independent audit, and that appropriate systems of controls are in place , in particular systems for monitoring risk, financial controls, and compliance with the law. • Monitoring the effectiveness of the governance practice under which it operates and making changes as needed • Overseeing the process of disclosure and communications.

14. Transparency & Objectivity • The board should be able to exercise objective judgement on corporate affairs independent, in particular, from management. • Board should consider assigning a sufficient number of non-executive board members capable of exercising independent judgement to tasks where there is a potential for conflict of interest. Example of such key responsibilities are financial reporting, nominations and executive and board remuneration. • Board members should devote sufficient time to their responsibilities. • In order to fulfil their responsibilities, board members should have access to accurate, relevant and timely information.

15. THANK YOU