May 29, 2006 – Karachi, Pakistan

1. The 2006 BCBS Guidelines on Enhancing the Corporate Governance for Banking Organizations May 29, 2006 – Karachi, Pakistan

2. Presentation Outline • Why corporate governance matters … in general and to banks in particular • What is special about bank vs. corporate governance • An introduction to the Basel Committee’s guidance on enhancing corporate governance for banking organizations • Concluding remarks

3. Why corporate governance matters to corporations in general … and banks in particular

4. Defining the Starting Point: What is Corporate Governance for Banks System by which corporations are directed & controlled The manner in which the business and affairs are governed by boards of directors and senior management, which affects how they: • Set corporate objectives • Operate the bank’s business on a day-to-day basis • Meet the obligation of accountability to their shareholders and take into account the interests of other stakeholders • Align corporate activities and behavior with the expectation that banks will operate in a safe and sound manner, and in compliance with applicable laws and regulations • Protect the interests of depositors

5. Corporate Governance Matters for Banks Themselves, and Economic Development Corporate governance: • Increases access to finance • Investment, growth, employment opportunities • Lowers cost of capital and improves valuation • Investment & growth opportunities • Improves operational performance • Better allocation of resources & better decision-making creates wealth • Builds/restores a bank’s reputation • Build trust between banks and its stakeholders, including shareholder, investors, regulator, depositors, employees – key in weak external environment • Less and better managed risk • Fewer defaults, fewer financial crises brings economic stability

6. In Particular Because of the Central Role Banks Play in the Economy • Well-governed banks will play a positive role in the economy … • Mobilizing and allocating society’s savings • Providing financing to firms (in particular in most developing countries w/i deep equity markets) • While poorly-governed banks can lead to disastrous outcomes • Bank crisis at Banco Ambrosiano (1972), Metallgesellschaft (1993), Barings Group (1995), Sumitomo (1996), Merrill Lynch (2001), Allied Irish Banks (2002), Freddie Mac (2003) • Asia and Russia financial crisis

7. Corporate Governance Also Matters to the Firms and Households Banks Lend to Banks’ valuation & cost of capital Bank performance, i.e. costs of financial intermediation Corporate governance affects Corporate governance of banks thus affects the cost of capital of the firms and households they lend to

8. Why Corporate Governance is Different for Banks Then for Firms (To a Degree)

9. Most banks are (publicly or privately held) companies themselves! And so: • Banks also have shareholders, directors and managers, with the same agency conflicts and costs • Corporate governance issues relevant to companies are thus also relevant to banks, e.g.: • A vigilant and independent board, • The protection of (minority) shareholder rights and • Appropriate disclosure and transparency

10. Yet Differences in the External Environment—and Hence Corporate Governance—Exist Heavier regulation,- Activity restrictions)- Prudential requirements (reserves, provisions)Public safety net  less mkt. discipline • Global Market Trends: Globalization, consolidation, new technology • Key economic role played by banks: Managing savings, providing financing Macroeconomic • Financial Structure: High debt/equity • Transparency: Opaque, culture of secrecy • Insider Role: Power role, conflict of Interests • Risk Management: More complex that for firms; internal audit more difficult • Employment & Incentives: Limited mobility Conflicts of interests more prevalent; harder to assess performance & risk higher chance misuse (tunneling) Microeconomic • Shareholders: More dispersed due to govt. restrictions • Regulator and supervisor • Depositor • Creditor • General public Less incentive to monitor directors and management govt. plays more active role AdditionalStakeholders Varying Externalities … lead to important differences … in economic behavior!

11. Studies and Practice on Bank Corporate Governance Have a Simple, Yet Telling Story • Banks are more difficult to monitor • Moody’s and S&P disagreed on only 15% of all ‘firm’ bond issues, but disagreed on 34% of all financial bond issues • Banks are more vulnerable • Recessions increases spreads on all bond issues, but increases spreads on riskier banks more than for ‘firms’ • Partly result of a flight to safety, but also greater vulnerability of banks compared to non-financial firms • In practice, banks with weak corporate governance have failed more often • Accrued deposit insurance, good summary measure of riskiness of banks, higher for weaker CG • State-owned banks enjoy even larger public subsidy, that is often misused: poor allocation, large NPLs, e.g., Indonesia, South Korea, France, Thailand, Mexico, Russia • Fiscal costs of government support up to 50% of GDP, large output losses from financial crises • Countries with weaker corporate governance and poorer institutions see more crises

12. What Does This Imply for Bank Corporate Governance and Regulation? • Two approaches to corporate governance related laws & regulations • Monitor banks through laws and regulations, based on international best practices (Basel I & II) • Empower banks through information and best practices, e.g. through a code based on the OECD Principles and Basel Committee Guidelines • Approaches not mutually exclusive: But what is best mix of private market and government oversight of banks? • Banks certainly can preempt regulatory (re)action by implementing good corporate governance

13. An Introduction to the Basel Committee’s Guidance on Enhancing theCorporate Governance of Banks

14. Background Information on the Basel Committee Guidance • Applies to a wide range of banks and countries  Including SOEs and FOEs; OECD & emerging countries • Applicable to diverse corporate and board structures • Principles, not rules • Not part of Basel II; applicable regardless • Not intended to add new layer of regulation or to replace national codes • Purpose: To assist banks to enhance their corporate governance frameworks and supervisors in assessing the quality of those frameworks

15. I. Ensuring For Good Board Practices • Are the bank’s board members qualified? • Right mix-of-skills in banking, finance & risk mgmt., cg, etc,. • Are the right election procedures in place • Can directors commit sufficient time and energy • Do they have a clear understanding of their role? • Setting overall strategy and managerial oversight, not day-to-day • Fiduciary duties of care and loyalty • To act in the interest of the company and all shareholders • Fit and proper tests; succession planning • Are the able to exercise independent judgment • Free from any conflicts of interest, and thus able to monitor financial reporting, remuneration and nomination procedures • Right board size, leadership and procedures in place? • Do key committees exist: audit, risk, cg/nomination, remuneration • Ability to obtain material information in timely manner • Do tough, but quality discussions take place

16. II. Establishing Strategic Objectives and a set of Corporate Values • Board should establish strategic objectives and ethical standards, conditio sine quo non to bank activities • Interests of stakeholders should be taken into account • Best if explicit rather than implicit, but corporate culture and ‘tone at the top’ turnkey (practice vs. theory) • Whistleblowing procedures should be implemented • Key issues to address: corruption & bribery, self-dealing, unethical behavior and conflicts of interest • Communicated throughout bank • Board is responsible for proper implementation of corporate governance, incl. internal/related party lending

17. III. Setting and Enforcing Clear Lines of Responsibility and Accountability • Clearly define authorities and responsibilities between shareholders, the board & management • Also important in group structures: • Board at group level responsible for overall strategy, oversight of subsidiaries, and risk/internal control structure of entire group • Board at subsidiary level retains cg responsibilities for subsidiary itself • Key issue: Open & transparent intra-group policies to deal with conflicts of interest among entities w/i group

18. IV. Ensuring For Appropriate Oversight by Senior Management • Senior managers should establish an effective system of internal control • E.g. “Four eyes principles” for key decision • Approved and periodically reviewed by the board

19. V. The Importance of Internal & External Controls and Audit to Sound Corporate Governance The external audit Importance of independent, external auditor is communicated throughout bank The internal audit Independent Internal controls Report to board’s audit committee Management letter issued Monitorscompliance with corporate governance rules, regulations, codes and policies • Direct reporting to the board’s audit committee Independence must be real: no/limited non-audit services At minimum, rotation of externalaudit partner

20. VI. Ensuring that Compensation is In-Line with a Bank’s Values, Strategy & Control Environment • Link board and management remuneration to long-term business strategy of bank • E.g. LT performance targets vs. st-volume or profitability • Options should only be granted under appropriate terms (time limits to hold/trade) and shareholder approval • Differentiate between executive & non-executive pay • Both should enable the bank to attract & retain top talent, but former has stronger linked to performance while latter to responsibility and time commitment • Independent remuneration committee sets remuneration  Board discusses and validate  shareholders (ideally) approve final package

21. VII. Conducting Corporate Governance in a Transparent Manner • Shareholders & other stakeholders can only effectively monitor directors & managers if bank is transparent! • Particularly important for banks’ objectives and structure • Material and timely disclosure is key, notably on: • Full set of financials (incl. notes) • Board and senior mgmt. structures • Basic organizational structure • Incentive structures (remuneration) • Bank-level corporate governance code and code of ethics • Nature and extent of transactions with affiliates and related parties • Disclose in annual report and publish on website

22. VIII. Know Your Structure • Establishing off-shore SPVs—although possibly serving legitimate business needs—pose real oversight and reputational risks • Require close attention by board • Risks need to be carefully analyses • Purpose, structure, volume of SPVs needs to be defined and disclosed • Clear policies for such structures need to be developed • Audit committee needs to pay close attention • Internal and external audit and controls need to include these structures

23. The Role of the Supervisor Supervisors should • Provide guidance to banks on sound & proactive corporate governance • Consider corporate governance as one element of depositor protection • Determine whether banks have adopted & effectively implemented sound corporate governance policies & practices • Assess the quality of banks’ audit and control functions • Evaluate the effects of the bank’s group structure • Bring to the board of directors’ and management’s attention problems that they detect through their supervisory efforts

24. The Role of Stakeholders • Shareholders – by exercising shareholder rights • Depositors and other customers – by avoiding business with unsound banks • Auditors – through an established and qualified audit profession, audit standards and communication to boards and supervisors • Banking industry associations –initiatives re. best practices and training • Professional risk advisory firms and consultancies –assisting banks in implementing sound corporate governance practices • Governments – through laws, regulations, enforcement and an effective judicial framework • Credit rating agencies – through review and assessment of the impact of corporate governance practices on a bank’s risk profile • Securities regulators, stock exchanges and other self-regulatory organizations – through disclosure and listing requirements • Employees – through communication of concerns regarding illegal or unethical practices or other corporate governance weaknesses.

25. And One Final Remarkable Feature “Know the corporate governance of your client”

26. Thank You for Your Attention