Assessing Corporate Governance in Banks: Lessons Learned from the Review of Banco de Oro

1. Assessing Corporate Governance in Banks: Lessons Learned from the Review of Banco de Oro Stilpon Nestor, Principal

2. The Agenda • Who: NeAd and G3 • What: Corporate Governance and its Values • How: BDO, a CG revue of an IFC investee bank • Lessons and conclusions: Corporate Governance issues in fin. institutions, improving the IFC approach, improving the revue process and results

3. I. Who: NeAd and G3

4. I. Nestor Advisors Ltd • The mission • Provide the highest quality corporate governance advice to corporations and financial institutions • The approach • Integrated and inter-disciplinary: top-level expertise by a multinational team of legal, financial and management/organization experts • Client-specific: tailor-made services to match client company profile, culture and specific needs with best practice and market expectations • Global: unrivalled proximity to and visibility with global institutional investors, the opinion leaders of market perceptions in corporate governance and a unique comparative perspective on legal and regulatory systems in different countries • Independent: one of the first pure-focus governance advisors; no conflicts of interest with other lines of business

5. I. NeAd Clients in 2003-2004 • A CAC-40 automotive manufacturer • A FTSE 100/NYSE-listed integrated oil company • A FTSE Eurotop 300/NYSE-listed integrated telecom operator • A FTSE Eurotop 300/NYSE-listed financial institution • An Asian emerging market integrated telecom operator • An Asian emerging market financial institution • A leading US proxy advisor • The Presidency of the EU Economic and Financial Council of Ministers (ECOFIN) • An OECD/European stock exchange and one major Asian emerging market stock exchange • The Swiss Economics Ministry (SECO) • The World Bank

6. I. The NeAd Principal • Principal of Nestor Advisors Ltd (2002-2003), London • Head of OECD Corporate Governance Department (1995-2002), Paris • Developed OECD Principles of CG, the global benchmark • Assisted large institutions/governments/World Bank in adoption/implementation of global benchmark • Worked in major OECD and emerging market economies on corporate governance, privatisation and corporate restructuring • Member of various Corporate Governance bodies • ICGN (biggest global investor forum), member of the Standards Committee of the board • OECD Steering Group on Corporate Governance, expert member for the 2003-2004 revision of the global benchmark • EASD/UK APCIMS (association of UK/EU brokers dealers) Chairman, Corporate Governance Committee • Numerous CG publications • Legal (corporate finance) background and education: • Thessaloniki Law School • Universite Libre de Bruxelles (Brussels) • Harvard Law School (LL.M 83) • Paris I Stilpon Nestor* Principal

7. I. : An Alliance that covers the world • G3 : a global alliance of 5 senior international CG consultants (of which NeAd is a member) • US (J. Lukomnik and S. Davis) • S. Africa (P. Armstrong) • Lat. America (P. Vasconcellos) • Europe (S. Nestor) • Combined experience of more than 75 years in CG in transition and developed economies. • Co-authors of national and global codes and co-founders of key institutions,

8. II. What: Corporate Governance and its Values

9. II: The subject matter: what is CG? • Board leadership: An independent, competent and engaged board, capable of exercising its strategic and monitoring functions • Transparency and disclosure : The availability of material, timely, actionable information to the board and investors • Alignment: The alignment of incentives of corporate insiders with those of other investors • Shareholder protection: A high level of protection against insider abuse to providers of outside finance • CG Commitment: Clear focus on establishing a maintaining an effective system for all of the above TRUST between boards, investors, management and stakeholders

10. II: The Value of Governance:Some Empirical and Survey Evidence • Over 10 years, well-governed companies across a wide range of sectors have seen superior valuation multiples of more than 8% over their badly governed peers. (Metrick, Ishi and Gompers 2002) • One standard-deviation improvement in governance brings an improvement in valuation multiples that ranges from 18% for companies in major OECD markets to 33% in major emerging markets. (Clapper and Love 2002) • Companies in the top governance quartile across 25 markets have 33% ROCE; companies in the bottom quartile have 15% ROCE. (CLSA 2001) • Global Institutional Investors managing more than 1 trillion of assets will pay a premium for well governed companies. The premium ranges from 12% in the UK to over 40% for Indonesia. (McKinsey 2001)

11. II: Overall Objectives of a Client Company • Increase investor trust and achieve lower cost of capital • Increase stakeholder trust (regulators, employees) • Improve performance by better organisation at the top • Limit compliance risk of the bank and legal risk of its officers

12. III. How: BDO, a CG revue of an IFC investee bank

13. III. Review Methodology • Map current practices and institutional framework • Questionnaire (IFC) • Review of documents • Review of local regulatory framework • Interviews (on site) • Meetings with policy makers/regulators • Presentation of initial conclusions to BDO • Comparison of material them against legal obligations, peer and best practice • Identify the strengths and weaknesses of current arrangements and “fit” with BDO’s strategic needs and cultural background. • Validate with G3 partners • Propose to IFC a tailor- made, balanced and prioritized programme for CG improvement in BDO

14. III. BDO: History and context • Part of the SM group since 1979 • Universal bank license since 1996 • Lowest NPL level in Philippine banking sector • Professionalization of management • …but family control remains with chairman TCS • Floated in PSE in 2001, but tiny free float (8%) • IFC convertible loan of 20 million in 2002 • Bond issue of 170 mil • Rapid expansion of the bank in 2001-2004: Balance sheet /revenue 25%, payroll 23% • Generali Pilipinas Life Assurance • Dao Heng bank • First E-bank. • Banco Santander • Equitable/PCI (under way) • Board with SM “friends”, 1 truly independent, one outsider (DHB), one IFC observer and open to the senior SM group members

15. III. Key overall findings: What worked yesterday might not work tomorrow • A committed, conservative and well-respected owner • …has assembled a strong management team • …that is driving a soundly-based but ambitious expansion program • But the board plays little role • … while top-level controls remain informal, highly- centralized, with little transparency • Meanwhile, regulators are raising their requirements and markets are more governance-conscious • Most governance-related loss of value occurs as a result of rapid expansion (organic or by acquisition) BDO should not become a victim of its own success

16. Addressing Threats Related to BDO Governance • Overload/bounded rationality Increase Decentralization • vertical • horizontal • Management complexity • More internal stakeholders • Lack of intra-group transparency of controls and decision making processes Increase Formalization: • Com. Charters • Policies • Practices/procedures • Market confidence • More external stakeholders • Succession issues at group level Independent pairs of eyes

17. IIIa. Key findings: Board leadership Situation Complication Recommendation Benefits Compliance responsible for corporate governance/ no board CG functions Honorary chairman, IFC observer, great differences in engagement Lack of board responsibility, impossible accountability Lack of transparency, no new blood, difficulties for team dynamics Upgrade Nomination Com into CG and Nom com: -Composition (“Swedish”) -Power: advisory (except formal nominations) -Tasks: Nominations, CG Code, CG Review, Board evaluation criteria, board composition 2. Create specific categories for Board observers and honorary members in CG manual - Gradually implement term limits for non-executive members Board takes responsibility for own destiny, -compliance function streamlined, -allows major shareholder to maintain board control transparently -meeting likely regulatory requirements 2. Raise engagement levels, maintain wise guidance from old hands and outsiders, meat best practice norms

18. IIIa. Key findings: Board leadership Situation Complication Recommendation Benefits Nomination com has exclusive right to determine director slate Remuneration of board is very low but some non executive members get paid as consultants Double trouble: High potential for abuse/ nom com cannot shape the board Low engagement incentives, threat to independence, 3. Two track nomination process: • Approval all nominations fulfilling minimum formalities • Recommend nominations that meet specific “fit” criteria • 4.Develop transparent board remuneration scales according to engagement level in committees or individual “grandfathering” positions. Raise investor confidence while maintaining board quality/ regulatory compliance Maintain independent status, meet regulatory requirements, incentivise collective board engagement

19. IIIa. Key findings: Board leadership Situation Complication Recommendation Benefits Risk committee is a management committee The board has little say in reflecting on big strategic decisions. There is no structured strategy debate. Risk issues in a bank are of strategic importance and may entail big conflicts of interest Owner is limited by bounded rationality. It is impossible to oversee management without a structured discussion 5. Create risk committee at board level and include at least 1 non-exec: -Develop risk philosophy -Set risk appetite and limits • Oversee/ regularly review all risk management processes • 6. Set board strategy calendar including yearly retreat. • -Build strict confidentiality obligations in bylaws • -Set objectives for CEO accordingly Meet best practice and possible compliance requirements, avoid conflicts while maintaining value of risk committee Ensures that strategy is set in a rationally optimal way; enhances the team dynamics of board

20. IIIb. Key findings: Quality of information Situation Complication Recommendation Benefits Audit committee meets quarterly and is only overseeing internal audit and receiving ext. audit report. Not fully independent. No board responsibility for adequacy of internal controls, independence of the audit process and integrity of financial information. All issues addressed at management (comptroller) or chairman level. Upgrade AuC: Full independence Responsibility for key accounting policies Review all financial disclosures Review of financial internal controls, including group Reception of compliance reports Full responsibility for appointing the ext. auditor, approving the audit plan, receiving the results. Review non-audit work Comply with BSP regulations, CG Code, global standard practice/ enhance effectiveness of controls by alleviating burden from chairman and establishing collective responsibility

21. IIIb. Key findings: Quality of information (con’t) Situation Complication Recommendation Benefits Audit committee meets quarterly and is only overseeing internal audit and receiving ext. audit report. Not fully independent. No board responsibility for adequacy of internal controls, independence of the audit process and integrity of financial information. All issues addressed at management (comptroller) or chairman level. Upgrade AuC: Review DOSRIEs Validate IA appointment discuss plan and yearly report Review all very large loans of more than 1 bil pesos Serviced by CS, not IA Annual calendar, frequent meetings Comply with BSP regulations, CG Code, global standard practice/ enhance effectiveness of controls by alleviating burden from chairman and establishing collective responsibility

22. IIIb. Key findings: Quality of information Situation Complication Recommendation Benefits 2. Current MIS depends on direct extraction of data from b-units. 3. Annual Report provides a short less than complete picture of the bank in terms of fin and non-fin information 2. Quality of performance indicators to top management and the board is limited and allows for only basic financial indicators 3. Outside investors cannot fully appraise the financials and the quality of management/governance 2. BOD should invest in a high quality, automated, group- wide MIS 3. Upgrade AR with, interalia: - Clear segment information -Fully diluted earnings -Governance review -Vision and strategy -Values -Key risks 2. High quality information to top management. Permits the board to maintain a balanced scorecard. 3. Realize value of good performance among investors, attract capital, build trust with regulators and other stakeholders.

23. IIIc/d. Key findings: Alignment and shareholder protection Situation Complication Recommendation Benefits Management receives no performance related pay and has little or no stock ownership 1. The Articles of Association preclude pre-emptive rights, allegedly to enhance future listings While management stays aligned with controlling shareholders its alignment with outside investors is minimal. 1. This seriously curtails investor rights The Chairman should head an ad hoc committee of the board for instituting long-term performance related pay (3-5 year rolling program) with a small but growing segment linked to the stock price. 1. Consider restoring pre-emptive rights Increased performance motivation, Alignment to shareholder value without jeopardizing the conservative approach of BOD. 1. Meet standard practice and lower investor risk

24. IIIe. Key findings: Commitment to good CG Situation Complication Recommendation Benefits Committees do not have clear mandates while the CG manual meets some of the BSP requirements without addressing some of the SEC ones. It I also unnecessarily repeats legal provisions. There is no high level document for the description of decision making process and authorities in the bank. Confusion even among senior BOD staff as to what are the tasks and scope of different part s of management and committees; amplified by constant regulatory changes and unclear legal status of regulations • Streamline BOD institutional framework: • Committee (board and principal mgmt) Charters • New comprehensive CG manual signed by the directors. Address conflict and conduct issues for directors, independent board advise, director information rights • General authorities document for every top level process. Facilitates management and board work and induction -Facilitates compliance -Facilitates external and internal communications

25. IIIe. Key findings: Commitment to good CG Situation Complication Recommendation Benefits 2. An independent director is the Corporate Secretary 3. Compliance as a full line function and internal audit responsibility for all internal controls 2. Board leverage within the organization is weak. Disqualification of Attn Estrella as independent director. 3. …means that compliance officer is responsible for everything andnothing and there actually might be less line responsibility 2. Create a powerful in- house office of Corporate Secretary, to support the work of the board and its committees and co-ordinate management input. 3. Split co-coordinating/ disclosure role from substantive and training responsibility role limited to: -AML -Non-financial int’l controls -Dotted line to AuC 2. Better functioning of the board, safeguarding of board independence 3. More effective compliance function, more line responsibility

26. BOARD CGN Committee • Chair • 1 maj. shareholder • 2 min. shareholders Risk Committee • President • Dep. Chair • 1 Ind. Director Trust Committee • Chair • Dep. Chair • President • 1 non-exec Audit Committee • 3 non-exec(incl. 2 independent) External Audit Trust Banking Group EXECUTIVE COMMITTEE Compliance/ Corporate Secretary Internal Audit Chair Deputy Chair President Credit Committee ALCo Credit/Risk Strategy/IR Legal Marketing HR B-Units Principal accountability Reporting relationship III. Proposed BDO Corporate Governance Chart

27. II. Lessons and Conclusions

28. IV. Corporate governance in the banking sector • Banks are corporate governance bell- weathers and their CG arrangements spill over the whole market • Regulation is extensive and often intrusive • Importance of compliance function • Internal controls • Fit and proper tests • Risk is a fundamental part of business strategy • Basel II and the role of the board in market, credit and operational risk • Risk philosophy, tolerance and appetite in credit and market risk • Proper controls and management of operational risks (audit committee) • Independent Audit function • Explicit management of conflicts between risk, credit and b-unit functions • Financial conglomerate and group issues

29. Peers Nordland bank 1 IV. Board Composition:EU Bank Peer Group Director Background Previous industry experience

30. Peers Nordland bank 1 IV. Board Composition: EU Bank Peer Group Non-Executive Main Professional Occupation Current Position

31. IV. Corporate governance in the banking sector • Issues in emerging economies • Weak regulation: fighting adverse selection through governance and transparency • Over-prescriptive regulation and conflicting requirements • Small expert pool: independence vs. competence • Politicized boards: priming the nomination function of the board • Directed credit and balancing sheet cleaning: more centralized governance? • Banks as parts of FIGs: controlling related party transactions, NPL controls, leveraging strong ownership

32. IV. Improving the IFC approach: where could G3 help • Policies and guidelines on nominee directors: profile, nomination process, rights, duties and conflict management • Model charters and policies for banks and their committees based on global best practice • Board guidelines • Authorities chart • Board committee charters • IA, CCO, CS mandate and duties • Key management committee charters (ALCO, Credit, OpsCom) • Feedback to home country authorities on regulatory and supervision inconsistencies • Benchmarking approach based on market expectations and peer practice

33. IV. An example of CG benchmarking:The NeAd Dashboard Methodology PENSION FUNDS ASSET MANAGERS Top 500 pension funds 5 366 383 million USD Top 500 asset managers 35 523 209 million USD Top 100 = 65% of the top 500 AUM Top 300 = 96% of the top 500 AUM Top 100 pension funds 3 479 637 million USD Top 300 asset managers 34 219 014 million USD No Code : 70 Code : 30 Code : 44 No Code : 256 including ISS 872 509 million USD 2 087 323 million USD 60% AUM top 100 1 392 314 million USD 40% AUM top 100 11 880 744 million USD 35% AUM top 300 22 338 270 million USD 65% AUM top 300 SELECTED UNIVERSE Sources: Pensions and Investments + Global Investor Magazine - 2003 Sources: Pensions and Investments P&I Watson Wyatt World 500 - 2003

34. IV. NeAd Dashboard Template Mother Template : 456 Corporate Governance Points Independent, Competent & Engaged Board Information to Investors and the Board Alignment of incentives Shareholders Rights and Protection 456 Corporate Governance Points Investor CG concerns mapped against Mother Template CG Score Template : 82 Corporate Governance Questions used to benchmark Companies against Investor’s expectations Independent, Competent & Engaged Board Information to Investors and the Board Alignment of Incentives Shareholders Rights and Protection 82 Corporate Governance Points CG SCORE

35. IV. Top Global Investors Concerns Ranked by AUM AUM (million USD) Existence of a remuneration committee Existence of an audit committee Audit committee independence Existence of a nomination/governance committee Composition/independence of remuneration committee members Majority of independent directors on the Board Composition/independence of nomination committee members Director shareholding requirements Shareholder right to elect directors Split CEO/Chairman Board role in succession planning Director tenure Presence of anti-takeover defenses Board role in appointing top executives Board evaluation 11 789 158 10 892 351 10 720 620 10 695 295 10 667 219 10 262 882 9 961 608 8 281 190 7 189 886 6 561 791 6 510 452 6 388 848 6 368 699 6 161 432 6 108 413

36. “Next-of-kin” peers Capitalization (as of 22/10/04 – source Bloomberg) Criteria of selection • Abbey National • Allied Irish Banks • Bank of Ireland • Commerzbank • Sanpaolo-Imi 13,04 bn EUR 11,78 bn EUR 10,29 bn EUR 8,91 bn EUR 17,49 bn EUR • European • Similar size • ADR level 2 or 3 Best Practice Peers Capitalization (as of 22/10/04 – source Bloomberg) Criteria of selection • European • Recognized as a CG leader • ADR level 2 or 3 • Deutsche Bank • UBS • HSBC 31,54 bn EUR 62,51 bn EUR 77,35 bn EUR Nordland Banks Capitalization (as of 22/10/04 – source Bloomberg) Criteria of selection • Nordland Bank 1 • Nordland Bank 2 • Nordland Bank 3 7,19 bn EUR 6,30 bn EUR 4,20 bn EUR • Listed bank • Nordland IV. EU Banking Peer Group

37. HSBC - 75,0 UBS – 73,2 Abbey – 70,1 Bank of Ireland – 64,0 Deutsche Bank – 61,6 Allied Irish Bank – 61,6 Unicredito Italiano – 54,3 Peers – 52,2 Bayerische Hypo-Und Vereinsbank – 51,8 Nordland Bank 1 Commerzbank – 41,5 San Paolo Imi – 39,0 Nordland bank 2 – 26,2 Nordland Banks Similar Peers Best Practices Nordland bank 3 – 8,5 IV. Sample: Overall Dashboard Ranking with more complete client disclosure CG Score Peer avg. 46,3 31,1

38. Investor weighting (million USD) Yes 10 695 295 Yes No No info ΙV. Sample: Nomination/Corporate Governance Committee Does the Bank have a nomination/corporate governance committee? Nordland Bank 1 No Peers

39. Peers (no Nordland) Nordland Bank 1 IV. Sample: Non executive directors share ownership Share ownership size (2003) No board holds collectively 1% or more of ordinary shares in issue The largest holding is for the HSBC board with 0.64% of ordinary shares in issue … but only 0,01% with non executive directors exclusively Average value held Ratio value held / annual remuneration Peers without UBS & HSBC Euros

40. IV. Improving the Review Process • Review team needs to be more than one • A two-step process (diagnostic presentation and separate presentation of tailor- made recommendations) is more effective • CG Reviews need to be followed by implementation audit in a year’s time • Client identification needs to be clearer: • Board advise or investor due diligence • Role of investment officer and CG unit

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