The importance of corporate governance

1. “The Importance of Good Corporate Governance for Banks”David CarseDeputy Chief Executive Hong Kong Monetary Authority 3 November 2000

2. The importance of corporate governance • Corporate governance is the system by which companies are directed and controlled. • Good corporate governance is a key element in improving economic efficiency. • Conversely, bad corporate governance, particularly in banks, can undermine economic and financial stability. • This was demonstrated by the Asian Crisis.

3. The role of bad corporate governance in the Asian crisis • Weak corporate governance in Asian banks (and their customers) 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 used to fund other parts of the group or the owners (connected lending) • banks were subject to political influence in their lending decisions • management was weak and lacked self-responsibility • growth was more important than return on capital • risk management was poor • lack of credit controls and skills • excessive risk concentrations in individual borrowers and sectors • excessive funding and currency mismatches

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, the HKMA considers that there was a vacuum in leadership in a few local banks during the Asian crisis because the board of directors did not play an effective leadership role. • This may result in either inadequate supervision of management or the main shareholders becoming directly involved in the running of the business. • In either case, the board of directors is bypassed and checks and balances are lost. • To address these issues the HKMA issued a guideline on corporate governance in locally incorporated authorized institutions in May 2000.

5. 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 • including liability for breaches of the Banking Ordinance • The use of auditors • including role of internal audit • Specific requirements

6. 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. • The HKMA has identified 8 types of risk for purposes of its supervision (i.e. credit, interest rate, market, liquidity, operational, reputation, legal and strategic risk). • The board should approve relevant policies to manage these risks while senior management should put them into effect. • It is important that the 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.

7. Specific Requirements 2. The board should ensure that the bank fully understands the provisions of section 83 of the Hong Kong Banking Ordinance on connected lending and establishes a policy on such lending. • Section 83 of the Hong Kong Banking Ordinance limits the unsecured advances of banks to connected parties (e.g. directors and their relatives). A breach of section 83 is a serious offence. • The board is required to 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.

8. 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. • The management letter should normally be received within 4 months from the financial year-end. The board should ask for management’s explanation if prolonged delay is experienced. • The board and/or audit committee should ensure appropriate action is taken to address any weaknesses identified in the management letter. • A copy of the management letter should be given to the HKMA.

9. 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. • Independent non-executive directors help to provide the necessary checks and balances and bring in outside experience. • The board should have at least 3 independent directors to provide a sufficient pool of independent directors to sit on committees (in particular the audit committee) and cover absences. • In cases where the chairman is also the chief executive of a bank, more than 3 independent directors may be required to provide a strong independent element on the board. • Banks should notify the names of their independent directors to the HKMA. The HKMA may require additional independent directors to be appointed.

10. Specific Requirements 5. The board should establish an audit committee with written terms of reference specifying its authorities and duties. • The audit committee serves as the board’s “eyes and ears” in monitoring compliance with board policies, regulations etc. It also provides oversight of the internal and external auditors and assists in providing independent review of the effectiveness of internal control systems. • The above functions should be performed by non-executive (preferably independent) directors to avoid conflicts of interest and ensure impartiality. • The audit committee should therefore be made up of non-executive directors, the majority of whom should be independent.

11. Specific Requirements 6. Board meetings of a bank should be held preferably on a monthly basis but in any event no less than once every quarter. • The board can only fulfil its responsibility if it meets frequently enough and receives sufficient information from management to enable it to monitor the bank’s financial position and performance. • Banks should keep full minutes of board meetings. • The HKMA will require banks to provide it with a record of the number of board meetings held each year.

12. Specific Requirements 7. 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. • While effectiveness of a director cannot be measured simply by attendance at board meetings, it is difficult for even the most competent individual to make a contribution if he/she does not turn up for meetings in the first place. • Participation of directors in board meetings can be facilitated by video or telephone conferencing. • The HKMA will monitor the attendance records of individual directors.

13. Specific Requirements 8. The HKMA will meet the full board of directors of each bank every year. • The HKMA’s intention is not to participate in board meetings but to strengthen communication between the HKMA and the banks at the highest level. • The meeting will enable the HKMA to convey first hand its views on the bank’s current financial position and quality of its risk management and internal controls and to communicate any major supervisory concerns. • The board will also have the opportunity to convey its views directly to the HKMA.

14. Questions raised on our Guideline • Is the HKMA interfering too much in the way in which banks choose to manage themselves? • Is too much burden being placed on the board, and on non-executive directors in particular, in terms of establishing policies and controls? • Should we draw a distinction between listed and non-listed banks? • Is it right to place more onerous requirements on banks compared with other companies, e.g. as regards the number of independent directors? • Where are truly independent directors going to be found?

15. The HKMA response • Promotion of good corporate governance falls clearly within the supervisory responsibilities of the HKMA. • Banks are different from other companies because of the nature of the risks they take on and because they are looking after other people’s money. • Corporate governance is therefore particularly important for banks, whether listed or non-listed. • 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.

16. The problem of independent directors • We do acknowledge that it is not easy to find truly independent directors or those that are prepared to oppose dominant shareholders. • There is also the risk that quasi-independent directors will be used to give a false impression of good governance. • The process of establishing a cadre of truly independent directors in Hong Kong and elsewhere in Asia will take time. • Training courses for directors and organizations to promote the use of independent directors like the UK PRO NED can help, as can the use of mechanisms such as board nomination committees.

17. The need for transparency • Financial disclosure and accountability are also important aspects of good corporate governance. • The increased focus on shareholder value means that banks need to be more open about their financial performance and the nature and size of the risks they are running. • Depositors and other providers of funds (including minority shareholders) also need sufficient information to be able to tell good banks from bad. • The HKMA has therefore focussed in the last six years on encouraging banks to disclose more information in their annual and interim accounts, in particular on asset quality.

18. Conclusions • The Asian crisis has demonstrated the need for Asian banks to improve their corporate governance through such means as: • giving greater prominence to the role of the board and outside directors in particular • introduction of professional management • greater transparency • effective internal and external audit • Globalization of financial services is in any case driving banks in this direction: • investors and fund providers will increasingly expect minimum standards of good governance • foreign banks operating in Asian markets will provide a role model • “Western” and “Asian” models of governance will converge • The Guideline issued by the HKMA is consistent with this global trend and is intended to keep Hong Kong banks at the forefront of good governance.