Importance of Corporate Governance in Banking Sector

1. Corporate Governance in Banks“New Banking Guidelines and Corporate Governance between Industries” David Carse Deputy Chief Executive Hong Kong Monetary Authority 26 April 2001

2. Introduction • My remit is to talk about our new banking guidelines and about corporate governance “between industries” • In practice, this means explaining why corporate governance is particularly important for banks as compared with other industries

3. The importance of corporate governance • Corporate governance is the system by which companies are directed and controlled • It is a key issue in relation to listed companies because of • the separation between ownership and management which listing promotes (giving rise to the so-called “agency problem”) • the need to protect minority shareholders • Hence, the focus in corporate governance on the need for independent directors

4. The special case of banks • The above considerations also apply in relation to listed banks • But there are other reasons why corporate governance is particularly important for banks, both listed and unlisted • high leverage exposes banks to risk and places increased focus on the need to protect creditors (not just investors) • banks are looking after other people’s money, but risk-taking is central to their activities • there are potentially huge systemic problems if banks get into difficulties

5. 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

6. The role of regulation • The potential for banking crisis explains why banks are regulated • Traditionally this has been a top-down process • regulators lay down rules and try to enforce them • Increasingly, however, the trend is towards supervision rather than regulation • This places the main emphasis on the key role of the directors and senior management in ensuring that banks are prudently managed

7. The role of supervision • The above trend brings corporate governance to the fore • recognises that banking is too complex to be run by regulators • tries to encourage self-responsibility in banks and to avoid moral hazard • Role of the supervisor is to put in place certain minimum standards, to monitor the performance of management and to take action if management is not doing its job properly

8. How can good corporate governance be promoted by supervisors? • Approval of directors and chief executives of banks and removal of those that are not fit and proper • Issuance of guidelines on corporate governance • Measures to encourage market discipline through disclosure and transparency

9. Approval of directors and chief executives • All directors and chief executives of banks in Hong Kong must be approved as fit and proper by the HKMA • Relevant criteria include • probity, reputation and character • knowledge, experience, competence, soundness of judgement • compliance record • business record and other business interests • Standards required vary according to the particular position to be held

10. Approval of managers • HKMA also recently proposed that it should also have the power to approve “managers” (i.e. senior executives below the level of CEO) • This attracted opposition from some banks who regarded it as too intrusive and as detracting from the prerogative of the board and CEO • As a result we have modified our proposal to • require notification of the appointment of managers • stipulate as one of the licensing criteria that banks should have adequate systems to ensure that managers are fit and proper

11. HKMA guideline on corporate governance • 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 • intended to reassert the role of the board of directors

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. The role of public disclosure in good corporate governance • As noted, the main responsibility rests with shareholders, directors and management • Banking supervisors 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

20. 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)

21. 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)

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. Bank disclosure in Hong Kong • HKMA publishes annual guidelines on financial disclosure which have helped to upgrade standards in Hong Kong • disclosure by banks in Hong Kong 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. Conclusions • Good corporate governance matters more for banks than for other companies • This is acknowledged by the special role that supervision plays in the process • But sound banks actually depend on three mutually reinforcing disciplines • internal discipline of the bank itself • external discipline of the supervisor • external discipline of the market