Good Corporate Governance-Its Importance For Banks And Challenges

Definition
Corporate governance is the set of processes, customs, policies, laws and institutions affecting the way in which a corporation is directed, administered or controlled. Corporate governance also includes the relationships among the many players involved (the stakeholders) and the goals for which the corporation is governed. The principal players are the shareholders, management and the board of directors. Other stakeholders include employees, suppliers, customers, banks and other lenders, regulators, the environment and the community at large. Corporate governance is a multi-faceted subject. An important theme of corporate governance deals with issues of accountability and fiduciary duty, essentially advocating the implementation of policies and mechanisms to ensure good behavior and protect shareholders. Another key focus is the economic efficiency view, through which the corporate governance system should aim to optimize economic results, with a strong emphasis on shareholders welfare. There are yet other aspects to the corporate governance subject, such as the stakeholder view, which calls for more attention and accountability to players other than the shareholders (e.g.: the employees or the environment).

Relevant rules include applicable laws of the land as well as internal rules of a corporation. Relationships include those between all related parties, the most important of which are the owners, managers, directors of the board, regulatory authorities and to a lesser extent employees and the community at large. Systems and processes deal with matters such as delegation of authority. The corporate governance structure specifies the rules and procedures for making decisions on corporate affairs. It also provides the structure through which the company objectives are set, as well as the means of attaining and monitoring the performance of those objectives.

Corporate governance is used to monitor whether outcomes are in accordance with plans and to motivate the organization to be more fully informed in order to maintain or alter organizational activity. Corporate governance is the mechanism by which individuals are motivated to align their actual behaviors with the overall participants.

How do we define “good” corporate governance?

Good corporate governance is about compliance and performance. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and shareholders and should facilitate effective monitoring, thereby encouraging firms to use resources more efficiently. Studies have found that firms with better corporate governance characteristics tend to perform better. Stock returns of firms with “good” corporate governance practices are significantly greater than returns for firms with “bad” corporate governance practices. It also reduces expropriation of corporate resources by managers and lenders and investors are more willing to provide funds leading to lower costs of capital. Good corporate governance can be pointed as:
• Board members act in the best interest of shareholders.
• The company acts in a lawful and ethical manner in all their dealings.
• All shareholders have the same right to participate in company governance and are treated fairly by the Board and management.
• The board and committees act independently of management
• All relevant company information is provided in a timely manner

Objective of the good corporate governance

The primary objective of sound corporate governance is to contribute to improved corporate performance and accountability in creating long term shareholder value.

Rights and equitable treatment of shareholders: Organizations should respect the rights of shareholders and help shareholders to exercise those rights. They can help shareholders exercise their rights by effectively communicating information that is understandable and accessible and encouraging shareholders to participate in general meetings.

Accountability: Accountability is a key objective of good governance. Not only governmental institutions but also the private sector and civil society organizations must be accountable to the public and to their institutional stakeholders. In general an organization or an institution is accountable to those who will be affected by its decisions or actions. Accountability cannot be enforced without transparency and the rule of law. In reality, the civil society must prevent itself from getting accustomed to poor governance.

Interests of other stakeholders: Organizations should recognize that they have legal and other obligations to all legitimate stakeholders.

Role and responsibilities of the board: The board needs a range of skills and understanding to be able to deal with various business issues and have the ability to review and challenge management performance. It needs to be of sufficient size and have an appropriate level of commitment to fulfill its responsibilities and duties. There are issues about the appropriate mix of executive and non-executive directors. The key roles of chairperson and CEO should not be held by the same person.

Integrity and ethical behavior: Organizations should develop a code of conduct for their directors and executives that promotes ethical and responsible decision making. It is important to understand, though, that systemic reliance on integrity and ethics is bound to eventual failure. Because of this, many organizations establish Compliance and Ethics Programs to minimize the risk that the firm steps outside of ethical and legal boundaries.

Disclosure and transparency: Organizations should clarify and make publicly known the roles and responsibilities of board and management to provide shareholders with a level of accountability. They should also implement procedures to independently verify and safeguard the integrity of the company's financial reporting. Disclosure of material matters concerning the organization should be timely and balanced to ensure that all investors have access to clear, factual information.

Responsiveness: Good governance requires that institutions and processes try to serve all take holders within a reasonable timeframe.

Consensus oriented: There are several actors and as many view points in a given society. Good governance requires mediation of the different interests in society to reach a broad consensus in society on what is in the best interest of the whole community and how this can be achieved. It also requires a broad and long-term perspective on what is needed for sustainable human development and how to achieve the goals of such development.



Good corporate governance objective is ensured when companies and stakeholders genuinely believe that it is in their own best interests to act ethically and to act according to best governance practices. Enforcement is important. But we have to admit that enforcement by itself will not keep bad actors out of the theatre. We will sometimes observe that some actors are bad, only after they have performed for some time. In the same way, there cannot be a set of laws or regulations that are complete in every way so as to be able to deal with every risk prevalent in the market. Many are the instances where market participants, especially those driven by short term self interest, look for regulatory loopholes and lacuna to further their interest without being unduly bothered by the underlying prudence of their actions.

Importance of corporate governance in bank:

In the case of banks, regulatory limits on ownership in banks are prescribed in a number of countries to prevent banks from being controlled by a single owner or a group of connected owners. However, a majority of countries in the world still do not have such regulations. In fact, according to a World Bank survey of 157 countries in 2003, 112 did not have regulations on ownership limits. Nevertheless, in many countries, indirect regulations such as limits on related-party transactions and fit and proper tests for bank directors and executive officers are in place to promote this aspect of good Corporate Governance, and I think, regulators genuinely believe that such practices would increasingly ensure the better risk management of banks, thereby leading to a more sound system. Corporate Governance is also increasingly acknowledged as being an important instrument to address “ownership issues” as well. With the current practices that are available worldwide which can hide the identities of true owners, it is now almost impossible for regulators to only rely on ownership limits to deal with undue influence, or be assured that seemingly unrelated parties are not actually related! Consequently, markets are increasingly looking towards the application of good Corporate Governance practice to overcome any ill-effects that may arise out of ownership concentration and it is generally believed that if good governance is in place, concentrated ownership, known or unknown, may not adversely affect the risk management process of the institution.
The Banking and financial sector is easily distinguishable from the others. A few distinguishing features stand out:

• Unlike normal business entities which are funded mainly through shareholders' funds; banks' business involves funds raised mainly through deposits. The business of raising public deposits places greater fiduciary responsibilities on the institution and its managers, since depositors' funds need to be safeguarded in a special way.
• Lack of corporate governance in bank can destabilize the financial system and pose systemic risks to the real economy. Banks determine which end-users receive financial resources and provide a means of payment. They also serve as a tool for the execution of monetary policy.

• Banks need to be perceived as both accountable and credible to depositors (i.e. they need to protect themselves against reputation risks) in order to manage the potential risk of a run on bank deposits. Banks are not free from the potential risk in which they suddenly become insolvent even if their assets are sound because of their high debt- equity ratio and the difference in maturity between liabilities (most deposits are available to depositors on demand) and assets (e.g. longer term loans). Moreover, the quality of banks’ main assets (loan portfolio) is often rather opaque to outsiders compared with those of non-financial firms;

• Banks perform as financial intermediaries by lending and investing the funds mobilized and funding economic activities of others.

• Banks are the agents of the payments system where they facilitate payments domestically and internationally, through various instruments such as bank accounts, fund transfers, credit cards, etc.

• Efficient regulation is extremely important to ensure sound corporate governance of banks in general.

• Banks are able to undertake all such business operations as a result of public trust and faith in the stability and soundness of the banks in particular and the system in general. The history on bank failures in many countries indicates that loss of public confidence in banks could be contagious and could easily lead to systemic banking crisis situations.

Overall, the banking business is the key for monetary conditions in a country. Bank deposit and lending business determines the supply, cost and availability of money. Money is created by the banking system through the legal tender issued by the Central Banks and/or Monetary Authorities. Since sight money created is payable by banks at any time through legal tender and technically, the banking system does not have funds adequate for meeting all such created money at any particular point of time. Banking business thus casts a huge responsibility on the monetary authorities to facilitate, regulate, and protect the banking and payments system.

Weak Corporate Governance (CG) can contribute to financial instability and that would increase the risk profile of companies in the corporate sector and expose the banks and financial institutions to a greater risk. In a more direct sense, weaknesses in CG arrangements in banks and financial institutions reduce their capacity to identify, monitor and manage their business risk and that can result in poor quality lending and excessive risk-taking by the financial institutions. Depending on the resilience of the financial institutions and markets, these risks have the potential to spread across the wider financial system. Needless to say that inadequate CG can also lead to a poor credit culture, excessive exposure concentration, poor management of interest risk/exchange risk and inadequacies in the management of connected exposures. Some of these risks, singularly or collectively, can lead to potential insolvency and financial instability.

The role good corporate governance can play in development of financial sector and in banking sector.

Corporate Governance is now identified and acknowledged as a powerful tool to generate trust and confidence in an institution. In that context, good Corporate Governance is essentially important for banks, because such institutions (a) deal with funds raised from the public; (b) are likely to encounter greater risks including frauds and failure; and (c) if such frauds or failures occur in such institutions, it may pose issues relating to public confidence in the financial system stability itself.

All these reasons have led to Banks tending to depend upon risk management practices based on principles of prudence rather than complying with only minimum requirements.

It is also as a result of such realization that many stakeholders and regulators are now consciously looking towards good Corporate Governance, as one of the prime instruments in its overall effort to maintain financial system stability. In Sri Lanka, the CBSL has already issued a voluntary code of best practice on Corporate Governance to banks. This was prepared by a Task Force consisting of persons from the banking and financial sector. But, we now believe that the time has come for us to move towards more stringent application of Corporate Governance Codes and therefore we are now in the process of drafting and issuing a new code of best practices on Corporate Governance to be made mandatory for banks.
Corporate governance can help in the development of financial sector in general and bank in particular in the following ways:
1. Foster effective supervision and regulation to built smooth and discipline financial markets
2. Improve institutional infrastructure-which have to include standard set of laws, uniform accounting standard and effective payment system for security settlement.
3. Enhance market discipline, surveillance and corporate governance-including transparency and adequate information system to the public at large.
4. Committed in WTO, entry of foreign banks may lead to increased competition, which in turn encourages domestic banks to emulate the corporate governance practices of their foreign competitors.
5. Good corporate governance systems will allow organizations to realize their maximum productivity and efficiency minimize corruption and abuse of power, and provide a system of managerial accountability.
6. Good corporate governance reduces emerging market vulnerability to financial crises, reinforces property rights, reduces transaction costs and the cost of capital, and leads to capital market development.
7. Studies have shown that good corporate governance practices have led to significant increases in economic value added (EVA) of firms, higher productivity, and lower risk of systemic financial failures for countries.
8. Promoting policies for financial sector and enterprise development in support of economic/investment diversification
9. Banks and financial institutions obviously need effective supervision and regulation, disciplined markets and surveillance and good corporate governance practice and appropriate infrastructure developments to bear the risk of competitive market.

The regulatory mechanisms ensuring good corporate governance in banks in Nepal are:
Main Laws Relating to Corporate Governance in Nepal
Companies Act, 2006
Act Relating to Securities, 2006
Insolvency Act, 2006
Act Relating to Bank and Financial Institution, 2006

Directives and -- Relating to Corporate Governance in Nepal
Nepal Rastra Bank Corporate Governance Directives for Bank and Financial Institutions
Nepal Rastra Bank Directives on Account Policy and Financial Statement
Nepal Rastra Bank Directives on Statistics and Statement subject to be submitted to NRB
Nepal Rastra Bank Directives on Promoter Share Transfer and sell
Securities Board of Nepal, Securities Listing By-laws
Securities Board of Nepal, Securities Registration and Issuance Permit Directives

Regulatory Authorities in Nepal
Company Registrar
Nepal Rastra Bank
Securities Board of Nepal
Nepal Stock Exchange Market
Insurance Committee
Various Law Courts

Foreign Regulatory Authority
World Bank
Asian Development bank

NRB directive:
The central bank has introduced higher corporate governance standards for banks and other financial companies as part of a wider program of financial sector reform. Accounting and auditing standards are being developed. And a number of draft laws have been prepared that should deepen and accelerate the reform process if passed and implemented.
Directive 6 also requires that boards follow a code of ethics developed by the NRB. Directors of all companies are prohibited from offering bribes, engaging in corruption, trading in the shares of the company, or having any conflicts of interest on appointment—though shareholders can waive the latter requirement. Banks and other financial companies cannot make loans to their directors. The draft company law would extend this limit to all companies.
While boards may have a minority of directors seen as representing smaller shareholders, there are no formal independence requirements in the law for listed companies. Starting in 2005 banks and other financial companies are required to appoint a “professional director” from a list approved by the NRB. The draft company law would also require that all companies have one or two independent directors.
To strengthen the banking system and prevent “willful default”, the NRB has directed that the board members and significant shareholders of companies in default can be “blacklisted” by the affected bank. Those blacklisted, and companies they control, cannot borrow, and cannot serve as bank directors. While blacklisting has encouraged the recovery of distressed loans and appears to be contributing to building a culture of repayment, some market participants feel— especially given the current political and economic environment—that the list has unfairly penalized the directors and significant shareholders of companies under legitimate distress, while weakening the concept of limited liability. Recently the NRB has revised the relevant directive to provide “non-willful” defaulters with a grace period.

Assessment:
The major stumbling block for good corporate governance in Nepalese context is the lack of meritocracy corporate culture. Here, position, power and relationship matter more than quality and skills of the people. People’s contribution in the organization is not evaluated objectively. The top management prefers personal favor and undue respect from their employees rather than performance. Corporate power and politics that favor and value more to the mediocre and subservient people is very much prevalent in most of the Nepalese organizations. And, this is here to stay as most of the people who have managed to climb the ladder by applying such means do not and cannot bring about positive charges. This apparently prevents practicing good corporate governance.
While the lack of good corporate governance in Nepal is a known phenomenon, there are of late certain efforts being made in this direction. Nepal Rastra Bank, the central bank of the country has recently issued a directive related to Good Corporate Governance to Commercial Banks. The directive has spelt out the details of dos and dont’s to ensure good corporate governance in the banking sector. While this is certainly a welcome and timely step taken by this government body, this is not enough. What is more important is that NRB itself should first epitomize this before it asks others to do the same. And, equally important thing is to have an effective and strong monitoring system to ensure effective implementation of the directives.
Nepal has initiated corporate governance reform in the financial sector and draft legislation has been prepared to spread reform to other companies. Fully tapping the potential of capital markets and professionalizing boards and management will require this legislation be passed and implemented and overall reform efforts continue. Good corporate governance ensures that companies use their resources more efficiently and leads to better relations with workers, creditors, and other stakeholders. It is an important prerequisite for attracting the patient capital needed for sustained long-term economic growth.
The challenges with regard to formulation and/or enforcing good corporate governance rules
Over the past few decades, the activities in the field of banking have been increasing rapidly and today a large number of new areas have been added to the traditional list of services provided by Banks. An examination of such lists would clearly indicate that Banks of today are performing many services that were hitherto provided by other service providers. We now see that the conventional difference between banking and other financial businesses, i.e., insurance and securities trading, has almost disappeared. In the meantime, the rapid development of debt securities markets too, has been posing new challenges to the traditional intermediation business of banks. All this has blurred the customary boundaries and there are many overlaps that have been created. Naturally these trends lead to new challenges to the Regulators of banks who now have to deal with these new multi-faceted conglomerates, instead of the traditional deposit taking/money lending institutions that were once-upon-a-time called “bank”. Therefore, today, a need has surfaced where several regulators are compelled to act as a group to undertake consolidated supervision of the financial institutions, especially financial conglomerates, and this is becoming increasingly common. Regulators now tend to enter into MOUs to share information under the current legal provisions, and they also have periodical meetings, sometimes in the form of financial system stability committees or as inter-regulatory institutions committees to assess potential systemic risks/crises and to develop crisis prevention and resolution measures. In fact, in some countries, Regulators now develop common tools to conduct financial “fire drills” to prepare for possible failures of large financial institutions, and such practices include various simulation techniques as well.

That is not all. The Regulators’ work has become even more complex due to the rapid internationalization of the banking system. Internationalization could take place in two ways: through ownership or business operations. “Ownership” involves international investors and/or international banks acquiring banks in other countries. Banking “business operations” gets internationalized through the use of modern IT where geographical boundaries and country regulatory boundaries are no longer applicable and it becomes increasingly difficult to identify a single particular location as being the operative area in respect of certain financial transactions. Modern IT and financial liberalization are the keys that have led to this type of banking internationalization. At the same time, it has provided for innovative electronic money and scripless settlements systems for cross-border financial transactions. Financial liberalization is now leading to banking internationalization where surplus funds flow cross-border to finance deficit units, i.e., international intermediation. In this background, it is now realized by Regulations that the high mobility of capital flows creates enormous risks to internationalized banks and to international systems, if the individual fund management systems of such banks are not sound. This requires Regulators to place even greater weight upon the efficacy of the governance systems since the failure of such institutions could be catastrophic to the well being of the entire global financial systems. In addition, the ill effects of money laundering, financing of illegal activities, and the financing of terrorism through the banking system are further risks that are faced by banks due to this growing internationalization. These too, need to be addressed by stakeholders who are involved in the development of the evolving systems. To deal with these challenges, Regulators now have to close ranks internationally as well, and attempt to harmonize prudential requirements to monitor risks of international financial conglomerates, and in this regard, we all must be somewhat relieved that the Basel capital accord has provided a clear framework for us to apply on the subject.

Corporate Governance for banks and financial institutions covers 8 principles. These are:

Principle 1: Board members should be qualified for their positions, have a clear understanding of their role in Corporate Governance and be able to exercise sound judgment about the affairs of the bank.

Principle 2: The board of directors should approve and oversee the bank’s strategic objectives and corporate values that are communicated throughout the banking organization.

Principle 3: The board of directors should set and enforce clear lines of responsibility and accountability through the organization.

Principle 4: The board should ensure that there is appropriate oversight by senior management consistent with board policy.

Principle 5: The board and senior management should effectively utilize the work conducted by the internal audit function, external auditors, and internal control functions.

Principle 6: The board should ensure that compensation policies and practices are consistent with the bank’s corporate culture, long-term objectives and strategy, and control environment.

Principle 7: The bank should be governed in a transparent manner.

Principle 8: The board and senior management should understand the bank’s operational structure, including where the bank operates in jurisdictions, those that may impede transparency (i.e. “know-your-structure”).

It is very clear today, more than ever, that Regulators also have a key role to play in achieving good Corporate Governance. In general, all regulations, in the Banking System, are intended in one way or another, to enforce prudential requirements on key areas of affairs of institutions to mitigate identified risks. Regulations on ownership, related party transactions, fitness and propriety tests for directors are directly based on modern Corporate Governance principles. However, the Basel Committee goes further and describes the role of supervisors in Corporate Governance by adding new parameters as well. These are:

Supervisors should provide guidance to banks on sound Corporate Governance and the pro-active practices that should be in place.

Supervisors should consider Corporate Governance as one element of depositor protection.

Supervisors should determine whether the bank has adopted and effectively implemented sound Corporate Governance policies and practices.

Supervisors should assess the quality of banks’ audit and control functions.

Supervisors should evaluate the effects of the bank’s group structure.

Supervisors should bring to the board of directors’ and management’s attention, problems that they detect through their supervisory efforts.

According to Basel recommendations, Corporate Governance should be promoted by other stakeholders as well. For instance,

Shareholders – through the active and informed exercise of shareholder rights;

Depositors and other customers – by not conducting business with banks that are operated in an unsound manner;

Auditors – through a well-established and qualified audit profession, audit standards and communications to boards of directors, senior management and supervisors;

Banking industry associations – through initiatives related to voluntary industry principles and agreement on and publication of sound practices;

Professional risk advisory firms and consultancies – through 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; and

Employees – through communication of concerns regarding illegal or unethical practices or other Corporate Governance weaknesses.

In a broader sense, mandating the banks and financial institutions to adhere to full disclosures of their operations would not only allow the markets, investors, depositors and others to keep a close watch on the financial institutions, but also provide an opportunity for other regulators also to be closely involved in supervising these institutions. For example, listed banks and financial institutions are not only under the supervisory arm of the Central Banks, but also the Securities & Exchange Commissions. In multi-regulatory and multi-supervisory systems like what is still prevalent in our part of the world, it is necessary to ensure that the regulatory and supervisory burden be shared by all who are responsible for regulating and supervising banking and financial institutions. This will also provide an opportunity to mitigate concentration of regulatory risks. In multi-regulatory regimes, it is particularly relevant to ensure that appropriate CG principles are laid down, so that all regulators are aware of the principles behind these governance rules that are introduced in the interest of the wider financial system stability.

In promoting sound CG, it is also necessary to develop an effective legal framework that specifies the rights and obligations of the institution, be it a bank or a finance company or other, its directors, shareholders and other stakeholders. The regulators, on their part, should initiate action to build capacity in CG at various levels, including the chairmen, the boards of directors and senior management of banks and financial institutions. The legal framework should also provide for disclosure requirements, facilitating the enforcement of the law.

Further, it is essential to encourage an effective financial news media, which deals with the importance of CG and educate the public. They should play a more responsible role in disseminating accurate information to the public and initiating a meaningful discussion on the subject.

Conclusion
The developments in Corporate Governance that are taking place all over the world are increasingly complex. It is almost impossible for those who are not undertaking full-time studies on the subject to keep pace with these developments. Yet, all of us who are interested in systems that stimulate business and keep the wheels of economies moving at a rapid space, would continue to have a strong interest in the subject. I am also hopeful that, the banking and financial community will continue to promote and foster these studies and practices since these provide the lubrication for the smooth functioning of our complicated financial systems in our ever-changing corporate regimes.

We also know that a large portion of global business is in the banking sector. In addition, all business entities, maintain direct relationships with banks and financial institutions. In that context, the pre-eminent position that is applicable to the banks and enjoyed by them cannot be over-emphasized or under-estimated. Therefore, our efforts to enhance the governance capabilities and capacities within banks and financial institutions have to be at the forefront of our agendas. The trend in the world of targeting governance practices in the banking and financial sector to be at the cutting edge of prevailing practices worldwide is a significant step in the right direction and should continue to be so in the future as well.