Corporate goverance

THE CORPORATE GOVERNANCE OF BANK
Chapter 1
INTRODUCTION
The Corporate Governance of Banks
The dominant model of corporate governance in law and economics is that the
corporation is a “complex set of explicit and implicit contracts.” In other
words, one shoud view the corporation as nothing more (or less) than a set of
contractual arrangements among the various claimants to the product and
earnings generated by the business.
Every business organization, including the corporation, “represent nothing
more than a particular ‘standard form’ contract. “ The very justification for
having different type of business organizations is to permit investors,
entrepreneurs, and other participants in the corporate enterprise to select the
organization design they prefer from a menu of standard-form contracts. The
virtue of the standard-form arrangement characteristic of modem corporate
enterprise to take advantage of an arrangement that suits the needs of
investors and entrepreneurs in a wide variety of situations.
Every business organization, including the corporation,”represents nothing
more than a particular ‘standerd form’ contract.” The very justification for
having different type of business organization is to permit investors,
entrepreneus, and other participant in the corporate enterise to select the
organization design they prefer from a menu of standard-form contracts. The
virtue of the standard-form arrangement charactreristic of modern corporate
law is that it reduces transaction costs by allowing the participants in the
corporate enterprise to take advantage of an arrangement that suits the needs
of investors and entreprerneurs in a wide variety of situations.
On a theoretical level, the problems of corporate governance result from the
existence of incomplete contracts. The rules of corporate governance are
K.G. MITTAL COLLEGE OF COMMERCE
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aimed at resolving the gaps left in these contracts in ways consistent with
maximizing the value of the firm. In the case of shareholders contingent
contracts in the United States, these background rules are called fiduciary
duties.
The economic justification for having fiduciary duties is straightforward:
“Fiduciary duties are the mechanism invented by the legal system for filling in
the unspecified terms of shareholders contingent [contracts].
The presence of fiduciary duties attempts to address these contingencies. In
this gap-filling role, fiduciary duties essentially call on directors to work hard
and to promote the interests of shareholders above their own.
The duty of care requires that directors exercise reasonable care, prudence,
and diligence in the management of the corporation. Director liability for a
breach of the duty of care may arise in two discrete contexts. First, liability
may flow from “ill advised or negligent” decision –making. Second, liability
may be the result of failure of the board to monitor in “circumstances in which
due attention would, arguably, have prevented the loss.” ‘Significantly, in
both classes of cases, directors are entitled to rely on information, reports,
statement, and opinions prepared by the company’s officers and directors as
well as outside consultants.
Separation of Ownership and Control
The problem of corporate governance is rooted in the Berle-Means (1932)
paradigm of the separation of shareholders ‘ownership and management’s
control in the modern corporation. Agency problems occur when the principal
(shareholders) lacks the necessary power or information to monitor and
control the agent (managers) and when the compensation of the principal and
the agent is not aligned. Several factors work to reduce these principal-agency
costs, The “market for managers “ penalizes management teams that try to
advance their own interest at shareholders’ expense.
On possible solution to the agency cost problem is to give shareholders direct
control over management. This is the case when management and
shareholders are the same party and control right automatically rest in the
hands of shareholders.
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Although these are potentially powerful concerns about the effectiveness of
shareholder control, recent research suggests that the more fundamental trade-
offs may guide the desired involvement of shareholders in corporate control.
Burkhart Gromb, and Panunzi (1997), for example shows that direct
shareholder control may discourage new initiatives on the part of managers.
These observations are consistent with real-world corporate governance
arrangements, which almost without exception limit direct shareholder
involvement. In some cases –particularly in the United State-this it facilitate
by relatively dispersed ownership.
Banks are organized in a variety of ways, from stand-alone corporate entities
and single bank holding companies to multiple bank holding companies and
the post-Gramm- Leach –Bliley Act (GLBA) diversified holding company.
This diversified structure permits such holding companies to reduce or
eliminate the firm- specific risks associated with the banks they own. The
GLBA significantly enhanced this diversification ability by permitting bank
holding companies and certain other restricted firms to become a new entity: a
financial holding company (FHC)
This dispersion of activity throughout the holding company structure also
gives incentives to bank holding companies to put more risky behavior in their
federally insured banks..
Special Problems of Banks
The discussion so far has focused on a general overview of corporate
governance. We now know turn to specific problems of banks and attempt to
address why the scope of the duties and obligations of corporate officers and
directors should be expanded in the case of banks. Our argument is that the
special corporate governance problems of banks weaken the case for making
shareholders the exclusive beneficiaries of fiduciary duties. Our focus here is
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on establishing why banks are not like other firms and thus should be treated
differently.
The Liquidity Production Role of Banks
Many different types of firms extend credit . Similarly, a variety of non-bank
firms most notably money market mutual funds and non-bank credit card
companies, offer the equivalent of a check transaction account. What
distinguished banks from other firms is their capital structure , which is
unique in to ways.First, banks tend to have very little equity relative to other
firms.
Second, banks, liabilities are largely in the from of deposits, which are
available to their creditors /depositors on demand, while their assets often take
the from of loans that have longer maturities (although increasingly refined
secondary market have mitigated to same extent mismatch in the term
structure of banks’ assets and liabilities ). Thus, the principal attribute that
makes banks banks as financial intermediaries ‘special’’ is their liquidity
production function. By holding illiquid assets and issuing liquid liabilities,
bank create liquidity for the economy.
The liquidity production function may cause a collective-action problem
among depositors because banks keep only a fraction of deposits on reserve at
any one time. Depositors because banks keep only a fraction of deposits on
reserve at any one time. Depositors cannot obtain repayment of their deposits
simultaneously because the bank will not have sufficient funds on hand to
satisfy all depositors at once.
The Deposit Insurance Fund
In the wake of the mass failure of depository institutions, Congress passed the
Banking Act of 1933 establishing the Federal Deposit Insurance Corporation
(FDIC) and giving the federal government the power to insure deposits in
qualified banks.The creation of federal deposit insurance has been
tremendously effective in preventing bank runs and keeping the failure of
individual banks from affecting the larger economy. Deposit insurance “has
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succeeded in achieving what had been a majer objective of banking reform for
at least a century, namely the prevention of banking panice.”
Deposite the positive effect of FDIC insurance on preventing bank runs, the
implementation of deposit insurance poses a regulatory cost of its own-it gives
the shareholder and manager of insured banks incentives to engage in
excessive risk-taking.
The problem of moral hazard is exacerbated in situations where a bank is at of
near insolvency. In such a situation, the shareholders have a strong incentive
to increase risk because they can allocate their losses to third-parties while
still receiving any gains that might result from the risky behavior.
The Conflict Fixed Claimants and Shareholders
A conflict between the interests of debt holders and the interests of
shareholders exists in every firm. Among any particular set of asset allocation
decisions, any investment strategy that increases risk will transfer wealth from
the fixed claimants to the residual claimants. This problem is raised to a new
dimension in the banking context because of the high debt-to-equity ratio and
the existence of deposit insurance.
In the publicly held corporation, the problem of excessive risk-taking is
mitigated by two factors. First, various devices serve to protect fixed
claimants against excessive risk-taking. Corporate lenders typically insist on
protection against is reduced to some extent because managers that threaten
their fixed claims. Second , risk-taking is reduced to some extent because
managers are not perfect agents of risk-preferring shareholders. Managers are
fixed claimants to that portion of
their compensation designated as salary. In addition, managerial incentives
for risk-taking are reduced, since managers have invested their non-
0diversifiable human capital in their jobs. This capital would depreciate
significantly in value if their firms were to fail
The adverts incentive for risk-taking caused by federal insurance is one reason
to have stricter accountability requirements for directors of blanks.
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Asset Structure and Loyalty Problems
The presence of federal insurance fund also increased the risk of fraud and
self-dealing in the banking industry by reducing incentives for monitoring . In
the 1980,it was estimated that fraud and self-dealing transaction
werte”apparent “ in as many as one-third of today’s bank failures. 28 A
similar statistic shows that between 12990 and 1991, insider lending
contributed to 175 of 286bank failures,29 Such behavior, of course, is a
possibility in any large firm, since it is inefficient for owners to monitor all
employees at all times. These sorts of problems are particularly acute in
financial institutions, however, because of the large portion of their asset held
in highly liquid form.
The same regulatory structure that creates a problems if excessive risk-taking
by banks also leads to a reduction in the normal levels of monitoring within
the firm, resulting in a higher incidence of bank failures due to fraud.
Shareholders have an incentive to monitor to prevent fraud and self-dealing in
banks, but such monitoring is notoriously ineffective in many cases because
individual shareholders rarely have sufficient incentives to engage in
monitoring because of collection-action problems.
One might argue that FDIC insurance simply replaces one set of creditors:
depositors, with another set of creditors: state and federal regulators. These
other creditors might more financially sophisticated than rank-and – file
depositors and thus appear in a better position to conduct the monitoring
necessary to prevent bank fraud.
Regulators have five main enforcement tools: cease and desist powers,
removal powers, civil money penalty powers, withdrawal or suspension of
federal deposit insurance power and prompt corrective actions powers. Cease
and desist powers generally address both unsafe and unsound banking as well
as violations of the law or regulations governing depository institutions.
Federal banking agencies also have to impose civil monetary penalties
against a banking institution and its affiliates. Prompt corrective-action
powers are also triggered by capital requirements, and these allow regulators
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to reach every significant operational aspect of a bank. Finally, the FDIC has
the authority to revoke a bank’s depositor insurance if necessary,
Nevertheless, replacing private- sector creditors with public-sector regulators
as the first line of the first line of defence against bank fraud and self-dealing
presents two problems. Private-sector creditors have stronger incentives than
public-sector regulators to monitor closely for fraud and self-dealing.
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Chapter 2
Is Corporate Governance Different for bank
Holding Companies?
Renee Adams and Hamid Mehram
The governance structure in banks should aim at
enhancing
Accountability and efficiency. Corporate governance in
Banks is different from that of manufacturing
compananies
Governance reforms required for banks should be
industry
Composition and compared to the board in
Manufacturing companies. Futher research on corporate
Governance in banks would determine the optimal board
Size that maximizes shareholder value subject to the
Constraints imposed on these firms.
Why Governance May Differ for Bank Holding
Companies
Shleifer and Vishny define corporate governance as dealing “with the ways
that suppliers of finance to corporations assure themselves of getting a return
on their investment” if managers operate independently, they may make
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financing, investment, and payout decisions that are detrimental to
shareholders.
The governance of banking firms may be different from that unregulated, non
–financial firms for several reasons. For one the numbers of parties with a
stake in an institution’s activity complicates the governance of financial
institutions.
As a result, the board of directors of a banking firm is placed in a crucial role
in its governance structure. Although the board of BHCs are assigned the
same legal responsibilities as other boards, regulators have placed additional
expectations on bank, as opposed to BHC boards that delineate their
responsibilities even further.
These and other differences in the operation of financial and non-financial
institutions have loed many to view regulatory oversight of the industry as a
substitute for corporate governance as less critical to the conduct and
operation of banking firms. ‘ Other argue that effective supervision could lead
to board oversight becoming a more critical element of banking firm
governance –dtha is, these could be complementary forces.
Thus, although in non-financial firm stock options may be appropriate
instruments to provide incentive for managers to create value, as well as to
protect the creditors of distressed companies, the options may conflict with
policy objectives that seek to protect the non-shareholding ,stakeholders, such
as depositors and taxpayers in financial firms.
Resolution of a financially distressed condition or outright in insolvency in
the banking industry can also have an important effect on top manager’s
incentive structures. In an unregulated environment, financial distress
generally leads to reorganization and in most cases, the incumbent top
manager is given the opportunity to turn the corporation around.
Our banking sample consists of thirty-five publicly traded bank holding
companies that were among the 200 largest top-tier BHCs in terms of book
value of assets for each year between 1986 and 1996. We collected additional
data on these firms for 1997-99; however, the number of firms
dropped to thirty-two during those years due to merger and acquisition
activity. For 1997,1998 and 1999, our sample consists of thirty-four, thirty-
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three, and thirty-two institutions, respectively. The requirement that the firm
be publicly traded makes it possible to collect data on internal governance
characteristics from proxy statements filed with the Securities and Exchange
Commission.
However, the requirement was imposed to study the role of governance in
firms where the potential impact of poor governance could be serious. The
assets of our sample of BHCs constitute a large fraction of total Industry
assets (32.30 percent of all top-tier BHC assets in 1990).
Findings from the Corporate Governance Variables
We emphasize that our analysis and comparison are not regression-based;
rather, our purpose is to compile a series of descriptive statistics in one place.
We choose manufacturing firms for comparison because their governance
structures have been analyzed more extensively by researchers than those of
firms in other industries; data availability was also a determining factor.
Board Size and Composition
An average of eighteen directors make up each BHC board, although there is
a wide distribution of board size in the sample (a minimum of eight directors
and a maximum of thirty-six). Over the sample period, it is apparent that
banking firm boards are becoming smaller. An average board in1999had 17
directors (median: 18), down from 20.3 in 1986 (median: 20). The trend is
consistent with the finding of Adams and Mehran (2002), who examine BHC
board size over the 1959-99 period. As Table 3 indicates, an average S&P
manufacturing firm had six fewer directors than an average BHC did over the
sample period. Booth, Cornett, and Tehranian (2002)also provide evidence
that banks have larger boards, using a sample of the 100 largest BHCs and the
10-0 largest manufacturing firms in 1999.
Since such regulatory restriction generally apply to board structure at the bank
level and not the holding level, which is the focus of this study, the regulatory
environment alone does not explain BHC board size and composition
However, regulation may have an indirect on the structure of BHD board to
the extent that it is influenced by the structure of the board of the BHC’S lead
bank and other subsidiary banks
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Board Activity
The number of annul board meeting for a bank, rather than a holding
company, is regulated at the state level. For example, during our sample
period, New York state member banks were required to have a minimum of
ten meetings per year.
State regulations on the number of meetings may influence the bank’s choice
of directors, since potential directors might have a better change of being
nominated if they live within proximity to the bank24
CEO Compensation
The increased use of stock option in executive compensation packages in
banking follows the pattern of other industries even though the growth and
level of stock option use are significantly lower than in manufacturing firms.
One potential explanation for the lower reliance on stock option in the
banking industry found in smith and watts (1992), who show that-growth
industries rely less on stock-based compensation (also see Mehram [1992]).
Smith and Watts suggest that board can observe, monitor,and evaluate the
action of CEOs of firms and industries with low-growth opportunities much
easier than they can in firms or industries with high-growth opportunities.
Thus, board in such industries should rely more on fixed rather than on stock-
based compensation.
Based on several proxies for growth opportunities advanced in the
literaturesuch as Tobin’s Q, market-to-book ratio, research-and-development-
to –sale ratio, and volatility-BHCs can be considered to have the
characteristics of low-growth firms.
Finally, given the low stock-return volatility in the banking industry, all else
equal, the value of stock option in banks will be lower. To compensate the
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CEO for a given dollar value of granted options, the has to give a larger
number of option relative to those given by an average manufacturing firm .
CEO Ownership
CEO ownership across BHCs and manufacturing firms may differ for several
reasons. One can argue that the samaller flow of options to bank holding
company CEOs leads to smaller ownership (We do not report the number of
options granted to CEOs).25
There may also be are a machanicial issue influencing the percentage of
ownership.Since BHCs are significantly more leveraged and have more assets
than manufacturing firm, ownership levels across the two types of firms may
not be compararable.29
An important insight of Modigliani and in a word with corporate taxes is that
the case flow claims of an ownership stake in an all-equity firm differ from
those associated with the percentage of equity ownership of an identical firm
with a positive debt level.
Block Ownership
To compile our statistics on block ownership, we rely on the CDA/Spectrum
Institutional Holding Database of Thomson Financikal. Institutional
shareholding is our proxy for monitotring by blockholders. However, the
corporate governance literature also emphasizes the importance of the identity
of the identity of blockholders and individuals, as opposed to just the size of
institution holdings.
Bank-affiliated institution are unlikely to moniter the BHC over the course of
these activities; therefore, to construct our summary statistics on institution
holders, we deledted all bank-affiliated institution from the list of institution
holders of our BHCs in all year.We also examined the identity of
institutional holding shares of manufacturing firms; however, found very few
cases of blockholders that were affiliated with manufacturing firms
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Chapter 3
Basel II and Role of Pillar 2:
Ensuring High Standards of
Corporate Governance
A.The Basel Committee
The Basel Committee on Banking Supervision is a committee, of banking
supervisory authorities, established by the Central Bank Governors of the G10
developed countries in 1975. The committee in 1988 introduced the concept
of capital Adequacy Framework, Known as Basel Capital Accord, with a
minimum capital adequacy of 8 percent. This accord has been gradually
adopted not only in member countries but also in more one hundred other
countries, including India.
B. Basel II: The New Basel Capital Accord
The committee issued a consultative document titled “The New Basel Capital
Accord” in April2003, to replace the 1988 Accord, Which re-enforce the need
for capital adequacy requirements under the current conditions. This accord is
commonly known as Basel II and is currently under finalization. Basel II will
be applied on a consolidates basis to internationally active banks.
However, supervisors are required to test that individual banks are adequately
capitalized on a stand – alone basis also. Basel II is based on three Pillars.
• Pillar 1 – Minimum Capital Requirements.
• Pillar 2 – Supervisory Review Process.
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• Pillar 3 – Market Discipline.
Pillar 1 discusses the calculation of the total minimum capital requirements
for credit, market and operational risks and maintains the level of minimum
capital adequacy at 8 percent. Pillar 2discussed the key principles of
supervisory review, risk management guidance and supervisory transparency
and accountability with respect to banking risks. Pillar 3 complements Pillar 1
and 2 by encouraging market discipline through enhanced disclosures by
banks to enable market participants asses the capital adequacy of banks.
D. Enhancing Corporate Governance in Banks
The Basel committee had issued, in August 1999, a guidance paper entitled
“Enhancing Corporate Governance for Banking Organizations” to supervisory
authorities Worldwide to assist them in promoting the adoption of sound
corporate governance practices by banks in their countries. The key features
of this guidance are discussed here.
I. Importance of Corporate Governance for Banks
Banks are a critical component of any economy. They provide financing for
commercial enterprises, basic financial services to a broad segment of the
population and access to payments systems. From a banking industry
perspective, corporate governance involves the manner in which their boards
of directors and senior managements govern the business and affairs of
individual banks, affecting how banks.
• Set their corporate objective;
• Run day-to-day operations;
• Consider the interests of various stakeholders;
• Align corporate actives with the expectation that bank will operate
in a safe and sound manner and in compliance with applicable law
and regulations; and
• Protect the interest of depositors.
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II. Sound Corporate Governance Practices for Banks
The Practices mentioned below are critical to any corporate
governance process in banks:
1. Establishing strategic objectives and a set of corporate values
communicated throughout the organization.
2. Strong risk management functions independent of business lines,
internal control systems, internal and external audit functions and
other cheeks and balance.
3. Special monitoring of risk exposures where conflicts of interests are
likely to be particularly great, including business relationships with
borrowers affiliated with the banks.
4. Setting and enforcing clear lines of responsibility and accountability.
5. Ensuring that banks’ board members are qualified for their positions,
have a clear understanding of their role in corporate governance and
are not subject to under influence.
6. Ensuring that there is appropriate oversight by senior management.
7. Ensuring that compensation systems are consistent with the banks,
objectives and control environment.
8. Conducting corporate governance transparently .
9. Flow of appropriate information internally and to the public.
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III. The Role of Supervisory Authorities in Ensuring
Effective Corporate Governance in Banks
Supervisors should be aware of the importance of corporate governance
and its impact on corporate performance. Supervisors should be attentive
to any warning signs of deterioration in the management of the banks
activities. They should consider issuing guidance to banks on sound
corporate governance and the proactive practices that need to be in place.
F. Corporate Governance for the Internal Ratings-
based (IRB) Approach to Credit Risk as per Pert 2
Pillar 1
I. IRB Approach [Internal Rating –based ]
Internal risk ratings are an important tool in monitoring credit risk. Internal risk ratings should be
adequate to support the identification and measurement of risk from all credit
risk and capital adequace
Subject to certain minimum condition and disclosure requirements, banks that
qualify for the IRB approach may rely on their own internal extimatest of risk
componets include measures of the probability of Default (PD) Loss Give
defatult (LGD) the Exposure at Default (EAD) and effective maturiys.
I. Corporate Governance
All material aspects of the rating and estimation process must be approved by
the bank’s board or a designated committee thereof and senior management .
Management must also ensure, on an ongoing basis, that the rating system is
operating properly.
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Bank must have independent credit risk control units responsible for the
design, implementation and performance of their internal rating system. They
must concentrate upon:
• Testing and monitoring internal grades;
• Production and analysis of summary report from the bank’s rating
system, to include historical default data, grade migration analyses and
monitoring of trends in key criteria;
• Implementing procedures to verify that rating definition are consistently
applied across departments and geographic areas;
• Reviewing and documenting any change to the rating process; and
• Reviewing the rating criteria to evaluate if they remain predictive of
risks.
Internal audit must review at least annually the
bank’ s rating system and its operation,
Good governance can be built based on the business practices adopted by
the board of directors and management. Many bank failures in the past have
been attributed to inadequate and inefficient management which enabled
beyond the level appropriate for the banks’ capacity. Some of the key
elements that Part 3 of Basel ll deals with theimportance of supervisory
review,its key priniciples, specific issues to be addressed under the
supervisory review process and supervisory transparency and accountability
itself in ensuring effective corporate governance. A discussin follws.
The supervisory review process of Basel ll is intented not only to ensure that
banks have adequate capitel to support all the risk in their business, but also to
encourage banks to develop and use better risk
This interaction is interaction is intended to foster an active dilalogue between
banks and supervisors such that when deficiencies are identified, prompt and
decisive action can be taken to reduce risk or restire capitial
The five main features of such a rigorous process are as follws:
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A sound risk management process is foundation for an effective
assessment of the adequacy of a bank’s capitel position. The analysis of
bank’s current and future capital requirements in relation to strategic
objectives is a vital elemente of the strategic planning process.
The bank’s bord should ensure that management establishes a framework for
assessing the various risk, to the bank,s capital and monitoting compliance
with internal policies. It should support strong internal contrls and
written polies and ensure that are effectively communicated throughout
the bank.
2. sound capital Assessment
fundamental principles of sound capital assessment include:
. policies and procedures designed to ensure that the bank identifies,
measures and reports all material risk;
. a process that relates level of the capital and states capiral adequacy
goals with respect to risk taking account of bank’s strategic business
plen; and
. a process of internal controls, reviews and adit to ensure the integrity
of the overall management process.
3. comprehensive Assessment of Risk
All material risks faced by banks should be addressed in the capital
assessment process. While not all risk can measured precisely , an
adequate and complete model should be developed estimate the various
risk, such as, credit risk, operational risk, interest rate risk, liquidity risk
and other risk like reputation and strategic risk.
4. monitoring and Reporting
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(The bank should establish an adequate system for monitoring and reporting
risk exposures in order to:)
• Evaluate the level and trends of material risks and their affect on
capital levels;
• Evaluate the reasonableness of key assumptions used in the capital
assessment measurement system;
• Determine that the bank hold sufficient capital against the various risk
in compliance with established capital adequacy goals; and
• Assess their future capital requirement based on the risk profile and
make necessary adjustments to the strategicplan
Internal Contral Review
The banks should regular review the following aspects of their system of
internal control to ensure well-ordered conduct of business:
• appropriateness of the capital assessment process;
• identification of large exposures and risk concentrations;
• accuracy and complecteness of data inputs into the assessment process;
• validity of scenarios used in the assessment process; and
• stress testing and analysis of assumptions and inputs
the supervisory authorities should regularly review the process by which
banks assets
review of work done by external auditors and periodic reporting.five main
features of this review are.
1. Review of Adequacy of Risk Assessment
Supervisors should assess the degree to which internal targets and processes
incorporate all material risks faced by the banks. Supervisors should also
review the adequacy of risk measures used in assessing internal capital
adequacy and the extent to which these risk measures are used operationally
in setting limits.supervisors should consider the results of sensitivity analyses
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and stress tests conducted by the banks and how these results relate to capital
plans.
2. Assessment Of Capital Adequacy
Supervisors should review the banks processes to determine that the target
levels of capital chosen are comprehensive and relevant to the current
operation environment,are properly monitored by senior management ,the
copositon of capital is appropriate for the banks’ business and the extent to
which the banks have provided for unexpected events in setting their capital
levels.
3. Assessment of the control Environment
Supervisors should consider the quality of the banks’ management
information systems, the manner in which business risk and activities are
aggregated and manageent’s record in responding to emerging or changing
risks. They should also consider the external factors like business cycle effects
and the macroeconomic environment in determining the capital levels.
4. Supervision Action
Having carried out the review process described above, supervisors should
take appropriate actions, sucsah as those set out under Principals 3 and 4
below, if they are not satisfied with
The result of the bank’own risk assessment and capital allocation.
5. Supervision should except banks to operate with a
buffer, over and above the Pillar1 capital requirement,
for a number of reasons.
A large number of banks prefer to be highly rated by internationally
recognized rating agencies.
In the normal course of business the type and volume of activities keep on
changing as well as the different risk requirements causing fluctuations in the
overall capital ratio.
It may be costly for banks to raise additional capital during emergency need.
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If it so happens, to fall below minimum regulatory capital requirements is a
matter of serious concern for banks.
Among other methods, the supervisors may set trigger and target capital ratios
or define categories above minimum ratios for identifying the capitalization
level of the banks.
II. Specific Issues to be Addressed Under the
Supervisory Review Process
1. Interest Rate Risk
If supervisors determine that banks are not holding capital commensurate
with the level of interest rate risk, they must require the banks to reduce their
risk, to hold a specific additional amount of capital or a combination of the
two.
2. Operational Risk
The Supervisors should examine whether the capital requirement generated
by the Pillar 1 calculation gives a consistent picture of the individual bank’s
operational risk exposure, for example, in comparison with other banks of
similar size and operations.
. Stress Tests under IRB: A bank should ensure that it has sufficient capital to
meet the Pillar 1 requirements and the results, in case of a deficiency, of the
credit risk stress test performed as part of the Pillar 1IRB minimum
requirements. Supervisors may review how the stress test has been carried out
and in case of a shortfall, react appropriately.
Residual risks: Supervisors should require banks to have in place appropriate
and effective written CRM policies and procedures in order to control the
residual risks, such as. Inability to seize or realize in a timely manner
collateral pledged, refusal or delay by a guarantor to pay and ineffectiveness
of untested documentation.
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Credit Concentration Risk: Supervisors should assess the extent of a bank’s
credit risk concentrations, how they are managed and the extent to which the
bank considers them in its internal assessment of capital adequacy. Such
concentrations include a significant exposure to an individual counterparty or
group of related counterparties, exposures to counterparties whose financial
performance is dependent on the same activity or commodity.
Securitization : Further to the Pillar 1 principle that banks should take account
of the economic substance of transactions in their capital adequacy
determination, supervisors should monitor whether banks have done so
adequately. As a result, regulatory capital treatments for specific securitization
exposures may exceed those specified in Pillar 1. The supervisors will have to
address the key issues involving securitization transactions such as
significanceofrisk transfer, market innovations, provision of implicit
support,first loss credit enhancements, call provisions and early amortization.
Supervisory Transparency and Accountability
Basel II Recognizes that the supervision of banks is not an exact science and,
therefore, discretionary judgements in the process are inevitable. Therefore,
supervisors need to carry out their review in a highly transparent and
accountable manner. Supervisors should make publicly available the criteria
used in the review of banks’ internal capital assessments. Where the capital
requirements are set above the minimum for an individual bank, the
supervisors should explain to the bank the risk characteristics specific to the
bank that resulted in the requirement.
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Chapter 4
Bank Performance and
Financial Condition of US Banks
Last year was exceptional in many respects, with the United States slipping
into a recession, the September terrorist attacks, the stock market declines,
and all of the related events. In response, the Federal Reserve reduced interest
rates at every meeting of the Federal Open Market Committee in 2001 and an
additional three times between meeting, for a total of eleven rate cutes
accumulating to 475 basis points.
The direct effect of the past year’s
stressful events were painful enough. In addition, abusive accounting and
corporate governance practices made conditions worse, as large corporate
bankruptcies imposed substantial losses on investors, lenders, and employees.
Throughout this period the US banking system remained strong, reporting
continuing record earnings and profitability, despite a slip in asset quality.
During the first half of
this years, US insured commercial banks earned more than $44.5 billion and
an annualized return on assets of 1.37 percent .
Net interest income was the primary driver of increased revenue, despite a
notable decline in commercial loan volume. Loans loss provisions remained
relatively high by the standards of most of the past decade but dipped notably
from the second half of 2001. Net charge –offs, which were concentrated
among commercial loans of large banks and credit card specialty lenders, also
dropped.
As noted current weaknesses appear to be largely within the commercial loan
portfolios of large regional and money center banks rather than those of
smaller institutions. Even the problems of large banks could be viewed as
mild, however, given the shocks felt by many in their customer base. Bank
performance also reflects, I believe, a grater awareness by institutions
23

throughout the banking system that they should promptly address problem as
they emerge.
If smaller banks, generally, are not seeing the commercial loan weakness that
some large institution are facing, which areas may present them with
heightened risks?
Most Reserve Banks are reporting generally weak commercial real estate
markets, as failing companies vacate office and retail space and renters into
single family homes commercial real estate credits are still performing
relatively well for this stage of the cycle, and my comments are not intended
to suggest a material concern.
The second areas of potential risk relates to interest rates. For the industry
overall, the Federal Reserve’s interest rate cuts last year certainly appear to
have helped bank earnings, but they present management with new
challenges, too. Lower rates Undoubtedly eased payment pressures on many
borrowers, and prevented further deterioration in the quality of bank loan
portfolios.
Indeed, many banks have responded to the low rates by sharply reducing their
investments in Treasuries and shifting funds into mortgage-backed securities
in the search for higher yields. That banking organizations, and investors
generally, should recognizes that domestic interest rates are historically low
and that the possibility for a rising rate environments should not be
overlooked. Even stable rates could present increased risks, if saving and
money market deposit accounts flow out of banks as quickly as they came in
when equity markets declined. At some point, even loyal customers- those on
fixed income, in particular-may blink and take steps to improve their own
yields.
Managing Risks
The health of financial institutions today is also a result of improvement in the
risk management process that has been ongoing at banks for years,
Increasingly, the entire risk management process has become data at lower
cost, but also improved techniques for measuring and managing risks.
24

As you are aware, bank regulators are working to develop a more modern
international approach to bank capital- called Basel II. Although those
standards, in the fist instance, are being designed to address changing
practices at large, internationally active banks, we can expect the lessons
learned about risks management to have much border effects. In quantifying
credit risk, large banking organizations are taking the lead, measuring a
borrower’s probability of default, the bank’s loss given default and its likely
exposure to the borrower at the time of default, taking into consideration
future draw downs.
The greater of credit scoring in retail transactions provides a stronger
framework to asses risk and ensure that loan pricing reflects the credit quality.
Such tools should perform even better as the effects of the most recent
economic slowdown are incorporated into bank statistics.
The measurement and management of interest rate risk has also improved
greatly in recent years, perhaps particularly at community banks. Asset.
liability committees at banks throughout the country now routinely consider
the results of models developed either internally or by vendors to identify the
market sensitivity of loans, investments, and deposits.
Recent abuses of corporate accounting practices and other matters provide
good lessons in risk management as bankers try to increase earning by cross-
selling more products,
Given the dominant role of credit risk at banks, to chief credit officer should
ensure that pressures to increase fee income do not lead to unacceptable levels
of credit risks.
(Sound corporate governance is an essential of a strong risk management
process. As banker and bank and bank directors ,you have specific
responsibilities to manage the risk at your financial institutions and effectively
oversee the systems of internal controls) Not only are the activities of central
to credit intermediation, but ,in this country , banks found their activities in
part with federally insured deposits. Those deposits are the lowest – cost
source of found that banks have, specifically because of the government
guarantee.
25

(Bank directors are not expected to understand every nuance of banking or to
oversee each transaction. They can look to management for that) They do,
however, have the responsibility to set the tone regarding their institution’s
risk taking and to oversee the internal-control processes so that they can
reasonably expect that their directives will be followed (They also have the
responsibility to hire individuals who they believe have integrity and can
exercise a high level of judgment and competence.
In the light of recent events , I might add that directors have the further
responsibility to periodically consider whether their initial assessment of
management’s integrity remains correct.
Interagency policy holds boards of directors responsible for ensuring
that their organizations have an effective audit process and internal
controls that are adequate for the nature and scope of their businesses.
Internal audit is a key element of management’s responsibility to
validate the strength of a bank’s internal controls.
Internal controls are the responsibility of line management. Line
managers must determine the level of risk they need to accept to run
businesses and must assure themselves that the combination of
earnings, capitel, and internal controls is sufficient to compensate for the
risk exposures. The results of these independent reviews should be
routinely reported to executive management and boards of directors.
The level of independence form executive management that a board
can demonstrate has, of course, become a far more visible and more
important factor in evaluating corporate governance.
Other provisions of the act set forth potentially broad ranging
standards affecting the way public companies compensate their
executives and directors and disclose their operating results. To
strengthen the role of outside auditors, the act also limits the non-audit
work such firms may perform for audit customers and creates an oversight
board to regulate and oversee audit work.
26

Indeed, beyond legal requirements, boards of directors and managers of
all firms should periodically test where they stand on business practices.
They should ask, for example, “ Are we getting by on technicalities,
adhering to the letter but not the spirit of the law ? Are we
compensating ourselves and others on the basis of contribution, or are
we taking ad vantage of our position?”
Ultimately, of course, market correct their excesses, and in this
context” markets” include both the public and private sectors. Obviously
, during the past year we’ ve seeen reactions not only form investors
and creditors, but also from law- makers and regulators, to observed
failures within corporate boardrooms. All of the action affect market
practice.
That includes maintaining sound ethical practices in protecting the
reputations of your banks. As we have seen from recent events, the
market’s response can be harsh.
Quality of Accounting practices
Uncertainty regarding the quality of corporate accounting standards
strikes at the heart of our capitalist system and threatens the efficiency
of markets. Investors and leders must be confident that understand the
risk they accept and that their counterparties are playing fair.
Informed and objective professionals can legitimately disagree on the best
accounting standard to apply to new types of tranasacations .That is part of the
challenge of keeping accounting standards current. The rapid pace of
business innovations makes it impractial to have rules in place to anticipate
every business transacation.
At the core of such accounting principles should be professional standards
that every corporate accountants and every outside auditor must follows. In
part, auditors should be required to ask themselves whether a particular
accounting method adequately represents the economics of tranasacation
and whether it provides readers with sufficient information to evaluate the
risks.
27

Rules alone, however, do not ensure good financial reporting. At Enron and
other companies, weak corporate governances practices apparently permitted
sham tranasactions and misleading financial reporting. Outside auditors erred
in trying too hard to pleasean important client.
For its part, the Federal Reserve is also willing to challenge accounting
interpretations that it sees as too aggressive.
In another example, the banking regulators have jointly issued for comment
new guidance related to credits cards. This guidance not only deals with
unacceptable practices, but also clarifies that revenue recognition of fees
billed to customers should the expected ability to collect those fees.
28

Chapter 5
The Role Of The Central Bank In
Promoting Corporate Governance
The growing competitiveness and interdependence between
Banks and financial institutions in local and foreign markets
Have increased the importance of corporate governance and
Its application in the banking sectpr.corporate governance in
Bank can be achieved through a set of legal, accounting
Financial and economic and integrity in banking sector is
Maintained , the need for uniform standards of the concept
Of governance in private and public sector banks in
emphasized.
The globalization process and the liberalization of money markets have
changed the ideas and visions of financial institutions all over the world.
Banks and financial institutions in local and foreign markets have acquired a
new spirit of competitiveness.
Governance in the banking sector is achieved through a set of legal,
accounting,
Financial and economic rules and regulations. These rules and regulations
direct the Management, govern performance , and assist in carrying out the
responsibilities of the Sector.
Corporate governance is important because it prohibits corruption ,
ensures integrity and also ensures. Corporate governance is important as well
to benefit and learn from the finding of the auditors and financial controllers
and to understand their oversight role.
29

Role of central Bank
Over the last yars, the central bank of Egypt has adopted a number of
measures that are consistent with principles set by the basel committee on
banking supervision .these measures are within the legal and regulatory
framework of the role of the central bank
In the area of prudential regulation and effective surveillance of the daily
operations of banks.
Setting a percentage of liquidity and reseves for banks is considered a
prudential mechanism and not a requirement that hinders banking activity.
Over the last years, some were complaining that banks are hindered by an
elevated percentage of legal reserves , and that is the reason for the liquidity
crisis. Bankers know very well how to manage their banks; the central
banks is here to assist the bankers, at the same time trigger the warning
Bell should such a situation arise.
The central bank of Egypt also emphasizes the measure of loan
concentration at the level of each bank. Loan concentration is not related to
the loan provided to one client . currently the law sets the exposure limit to
each client at 30 percent . we also have loan concentration limits for foreign
banks . the restriction is that all egyptlion money or all egyption money or
all egyption originated money should not be deposited at foreign
representation banks.
However connections related to more than one activity will lead a
bank to be exposed to problems that have been avoided to conneted lending
last November 2002
There will be a conflict of interest. You cannot be a borrower and a
shareholder in the same time. Certainly, there will be a confict of interest
between your position as a shareholder who wants to puesue the maximum
profit and a borrower
The same to the member of the boards of directors. We emphasize that the
member of the board of directors. We emphasize that the member of board of
30

directors shoud not be a borrower from the same bank; otherwise things will
be mixed up and there will be conflict of interests.
Direct conflict of interst, each non-executive board member should sign a
certification and submit it to the board of the bank sating that he has no
conflicts of interst and that he will refrain from mixing his private work or
business and his work as a board member.
It is advisable that audit committees have three non-executive board members.
Committee members should be given power and authority to review the
bank’s performance, works, disciple, and manuals, and the extent of their
compliance to the manuals.
The report of the auditing committee should be available for the whole board
for revision and the finding should be presented by the head of the auditing
committee.
If the bank’s auditing committees follow internationally recognized standards
and practice, I think that there will be some sort of adherence to the discipline.
The establishment of inspection committee or department is not the issue; the
issue is these department of inspection committees or departments is not the
effective. If inspection committees sumit their report to the chairman of the
board of directors, we should say that this is wrong. These committees needs
to submit reports and make its information available to the entire board of
directors, and not to the chairan or executive director.
I think there is no contradiction between the internal inspection departments
and internal auditing committees . Infection departments have a daily
responsibility to check compliance with manuals .
Shareholders Rights
It is very important that the shareholders have the conviction to take and to
give. In many cases , we find that shareholders in companies not to speak of
banks, are interested only only to no about their dividends . if we assume that
this is the right think to do than, there controlling role is absent . Some share
31

holders want only to receive decedents has investors but are not aware that
they have controlling and supervisory role
Shareholders need to undertake their supervisory role within all institutions.
We as a supervisory institution for the banking sector should perform our role
so, if there is internal control at the banking via corporate governance and
external controls from the central bank, this would be very beneficial to the
country.
If we look at the control factor inside the banks boards and make a link
between members of the banks boards of directors and their ownership we
might discover that a specific shrereholder might control the banks
management and control its decisions. Ownership might be 49 percent ina
specific institutions and other ownership might be 20 or 21 percent and be
consider it a sister company and not an affiliated company
In the coming period, we are concerned with new bank laws and we will make
sure that the concept of control leads to quality and not to monopoly.
Monopoly of thought and monopoly of leadership in the bank in a wrong
direction or leading the board in a wrong direction will be given enough
consideration.
Corporate governance criteria can not be effective if it is only on paper.
Proper, sound, and effective corporate governance criteria are those that
incorporate a punishment and reward system. The central bank’s ability to
implement its policies and decisions within the banking sector serve as a
corrective and disciplinary mechanism. The bank’s board of director and it’s
general assemblies also need to be committed to undertaking corrective
measures when necessary.
When, for example, the audit committees in the banking sector notifies the
board about some specific audit findings, the board needs to immediately take
corrective measures rather than rushing to defend its decisions or before
rushing into defending the executive management of the bank, as it is possible
that the executive might be wrong .The central bank also needs to be effective
in implementing measures when discovering malpractices in the banking
sector or the performance of the banks boards of directors, without using
double standardsrecognized criteria. Everyday there are new concepts.
32

Chapter 6
Public Sector Banks and
The Governance Challenge
Historical Concept
India had a fairly well developed commercial banking system in existence at
the time of independence in 1947.The Reserve Bank of India (RBI) was
established in 1935.While the RBI became a state-owned institution from
January 1, 1949, the Banking Regulation Act was enacted in 1949 providing a
framework of regulation and supervision of commercial banking activity. The
first step towards the nationalization of commercial banks was the results of a
report (under the aegis of RBI) by` the Committee of Direction of All India
Rural Credit Survey (1951) which till today is the locus classicus on the
subject .Thus the Imperial Bank was taken over by the Government and
renamed as the State Bank of India(SBI)n the July 1,1955 with the RBI
acquiring overriding substantial holding of shares. A number of erstwhile
banks owned by princely states were subsidiaries of SBI in 1959.
To meet theses concerns, in 1967 , the Government introduced the
concept of social control in the banking industry . The scheme of social
control was aimed at bringing some changes in the management and
distribution of credit by the commercial banks.
Political compulsion then partially attributed to inadequacies of the social
control, led to the Government of India nationalizing, in 1969, 14 major
scheduled commercial banks the needs which had deposits above a cut-off
size. The objective was to serve better the needs of development of the
economy in conformity with national priorities and objectives.
From the fifties a number of exclusively state-owned development financial
institution (DFIs) were also set up both at the national and state level, with a
33

lone exception of Industrial Credit and Investment Corporation of India
(ICICI) which had minority kprivcate share holding.
Reform Measures
The major challenge of the reform has been to introduce elements of market
incentive as a dominant factor gradually replacing the administratively
coordinated planned actions for development. Such a paradigm shift has
several dimensions, the corporate governance being one of the important
elements. The evolution of corporate governance in banks, particularly in
PSBs, thus reflects changes in monetary policy, regulatory environment, and
structural transformations and to some extent, on the character of the self-
regulatory organizations functioning in the financial sector.
Policy Environment
During the reform period, the policy environment enhanced competition and
provided greater opportunity for exercise of what may be called genuine
corporate element in each bank to replace the elements of coordinated actions
of all entities as a “joint family “ to fulfill predetermined Plan priorities . The
measures taken so far can be summarized as follows.
First, greater competition has been infused in the banking system by
permitting entry of private sector banks (9licences since 1993), and liberal
licensing of more branches by foreign banks and the entry of new foreign
banks. With the development of a multi- institutional structure in the financial
sector non-bank intermediation has increased, banks have had to improve
efficiency to ensure survival.
Second, the reforms accorded greater flexibility to the banking system to
manage both the pricing and quantity of resources. There has been a
reduction in statutory preemptions to less than a third of commercial banks
resources. Valuation of banks’ investments is also attuned to international best
practices so as to appropriately capture market risks.
34

Third, the RBI has moved away from micro-regulation to macro-management.
RBI has replaced detailed individual guidelines with general guidelines and
now leaves it to individual banks’ boards to set their guidelines on credit
decisions.
Fourth, to strengthen the banking system to cope up with the changing
environment , prudential standards have been imposed in a progressive
manner.
Fifth, an appropriate legal., institutional, technological and regulatory
framework has been put in place for the development of financial markets.
There is now increased volumes and transparency in the primary and
secondary market operations. Development of the Government Securities,
money and forex markets
Interest rate channel of monetary policy transmission is acquiring greater
importance as
Compared with the credit channel .
Regulatory Environment
Prudential regulation and supervision have formed a critical component of the
financial sector reform programme since its inception, and India has
endeavoured to international prudential norms and practices.
The Banking Regulation Act 1949 prevents connected lending (i.e. lending
by banks to directors or companies in which Directors are interested.
Periodical inspection of banks has been the main instrument of supervision,
though recently there has been a move toward supplementary ‘on-site
inspections’ with ‘off-sites surveillance’. The system of ‘Annual Financial
Inspection’ was introduced in1992, in place of the earlier system of Annual
Financial Review/Financial Inspections.
A high powered Board for Financial Supervision (BFS), comprising the
Governor of RBI as Chairman, one of the Deputy Governors as Vice-
chairman and four Directors of the central board of RBI as members was
constituted in 1994 , with the mandate to exercise the Power of supervision
35

and inspection in relation to the banking companies , financial institution and
non-banking companies.
A supervisory strategy comprising on- site inspection , off –site
monitoring and contral systems internal to the banks , based on the camels
(capital adequacy, asset quality , management , earnings , liquidity and
systems and controls ) methodology for banks have been instituted . the RBI
has instituted a mechanism for critical analysis of the balance sheet by the
banks themselves and the presentation of such analysis before their boards to
provide an internal assessment of the health of the bank.
Keeping in line with the merging regulatory and supervisory standards
at international level , the RBI has initiated certain macro level monitoring
techniques to assess the true health of the supervised institutions. The format
of balance sheets of commercial banks have now been prescribed by the
RBI with discosuresure standards on vital performance and growth indicators
, provisions, net NPAs, staff productivity , etc. appended as ‘notes of
accounts’. These proposed additional disclosure norms would bring the
disclosure standards almost on par with the international best practice.
Structural Environment Of Banking
The nationalized banks are enabled to dilute their equity of Government of
India to 51 percent following the amendment to the Banking Companies
(Acquisition & Transfer of Undertakings) Acts in 1994, bringing down the
minimum Government’s shareholder to 51 percent in PSBs. RBI’s
shareholding in SBI is subject to a minimum of 55 percent.
The diversification of ownership of PSBs has made a qualitative difference to
the functioning of PSBs since there is induction of private shareholding and
attendant issues of shareholder’s value, as reflected by the market cap,
representation on board, and interests of minority shareholders. There is
representation of private shareholder when the banks raise capital from the
market.
The governance of banks rests with the board of directors. In the light of
deregulation in interest rates and the greater autonomy given to banks in their
operation, the role of the board of directors has become more signification.
36

During the years, Board have been required to lay down policies in critical
areas such as investments, loans, asset- liability management, and
management and recovery of NPAs. As part of this process, several Board
level committee including the Management Committee are required to be
appointed by banks.
Government introduced a Bill in Parliament to omit the mandatory
provisions regarding appointment of RBI nominees on the Boards of public
sector banks and instead to add a clause to enable RBI to appoint its nominee
on the boards of public sector banks if the RBI is of the opinion that in the
interest of the banking policy or in the public interest or in the interest of the
bank or depositors, it is necessary so to do.
Appointment of Chairman and Managing Directors and Executive Derectors
of all PSBs is done by Government., The Narasimham Committee II had
recommended that the appointment of Chairman and Managing Director
should be left to the Boards of banks and the Boards themselves should be
elected by shareholders
Appointment as well as removal of auditors in PSBs require prior approval of
the RBI. There is an elaborate procedure by which banks select auditiors
from an approved panel circulated by the RBI. In respect of private sector
banks, the statutory auditors are appointed in the Annual General Meeting
with the prior approval by the RBI.
Self Regulatory Organisations
India has had the distinction of experimenting with Self Regulatory
Organisation (SROs) in the financial system since the pre-independence days.
At present, there are four SROs in the financial system- Indian Banks
Association (IBA), Foreign Exchange Dealers Association of India (FEDAI),
Primary Dealers Association of India (PDAI) and Fixed Income Money
Market Dealers Association of India (FIMMDAI).
The IBA established in 1946 as a voluntary association of bankis, stove
towards strengthening the banking industry through consensus and co-
37

ordination. Since nationalisation of banks, PSBs tended to dominate IBA and
developed close links with Government and RBI. Often, the reactive and
consensus and coordinated approach border on cartelisation. To illustrate,
IBA had worked out a schedule of benchmark service charges for the services
rendered by member banks, which were not mandatory in nature, but were
being adopted by all banks.
Responding to the imperatives caused by the changing scenario in the reform
era, the IBA has , over the years, refocused its vision, redefined its role, and
modified its operational modalities.
In the area of foreign exchange, FEDAI was established in 1958, and banks
were required to abide by terms and conditions prescribed by FEDAI for
transacting foreign exchange business. In the light of reforms, FEDAI has
refocused its role by giving up fixing of rates, but plays a multifarious role
covering training of banks’ personnel, accounting standards, evolving risk
measurement models like the VaR and accrediting foreign exchange brokers.
In the financial markets, the two SROs, viz , the PDAI and the FIMMDAI are
closely involved in contemporary issues relating to development of money
and government securities markets. The representatives of PDAI and
FIMMDAI are members of important committees of the RBI, both on policy
and operational issues. To illustrate, the Chairman of PDAI and FIMMDAI
are members of the Technical Advisory Group on Money and Government
Securities market of the RBI.
Current Proposal
It would be evident that the Report ofAdvisory Group contain far
reaching proposal to improve corporate governance and many if not all
do require legislative processes and
they are necessarily time consuming and often realisable only in
medium-term. While
proceeding with analysis and possible legislative actions, it may be
necessary to consider
and adopt changes that could be brought about within the existing
legislative.
38

To this end, Governor Jalan in his Monetary and Credit policy
statement of October 2001 constituted a consultative Group of
Directors of banks and financial institutions (Chairman Dr. A S
Ganguly) to review the supervisory role of Boards of banks and
financial institutions and to obtain feedback on the functioning of
the Boards vis-à-vis compliance, transparency , disclosures, audit
committees etc., and make recommendation for making the role of
Board of Directors more effective. The Group made its
recommendations very recently after a comprehensive review of the
existing framework as well as of current practices and
benchmarked its recommendations with international best practices
and benchmarked by the Basel committee on Banking Supervision,
as well as of other committees and advisory bodies, to the extent
applicable in the Indian environment.
Tentative Issues and Lessons
Corporate governance in PSBs is important, not only because PS Bs
happen to dominate the banking industry , but also because, they
are unlikely to exit from banking business though they may get
transformed. To the extent there is public ownership of PS Bs, the
multiple objectives of the government as owner and the complex
principal- agent relationships cannot be wished away. PS Bs cannot
be expected to blindly mimic private corporate banks in governance
though general principles are equally valid. Complications arise
when there is a widespread feeling of uncertainty of ownership and
public ownership is treated as transitional phenomenon. The
anticipation or threat of change in ownership has also some impact
on governance, since expected change is not merely of owner but
the very nature of owner. Mixed ownership where government has
controlling interest is an institutional structure that poses issues of
significant difference between one set of owners who look for
commercial return and another who seeks something more and
different, to justify ownership.
The most important challenge faced in enhancing corporate
governance and in respect of which there has been significant
though partial success relates to redefining the interrelationships
between institution within the broadly defined public sector i e.,
39

government ,RBI and PSBs and PSBs to move away from a model of
planned development.)
The central bank also had to move away from sharing the nitty gritty of
developmental schemes with government involving micro regulation, to a
more equitable treatment of all banks as regulator and standareds.
Another noteworthy aspect of enhancing corporate governance is
narrowing of gap between PSBs and other banks in terms of the
policy , regulatory and operating environment, apart from some
changes in ownership structures with attendant consequences. The
PSBs as hundred percent owned entities with no share value quoted
in stock exchanges accounted for over three quarters of banking
business seven years ago, while they now account for less than a
quarter.
Random Thoughts
The Indian experience provokes some thoughts on a few fundamental
issues in regard to PSBs and corporate governance. First, is public
ownership compatible with sound corporate governance as generally
understood? Since various corporate governance structures exits in
different countries . Government ownership of a bank , unless government
happens to have such a stake purely as a financial investment for return,
necessarily has to have the effect of altering the strategies and objectives as
well as structure of government. Government as an owner is accountable to
political institutions which may not necessarily be compatible with purely
economic incentives.
The mixed ownership brings into sharper focus the divergent objectives of
shareholding and the issues of reconciling them, especially when one of
the owners is government. In such a situation, one can argue that as long as
the private shareholder is aware of the special nature of shareholding , ther
should be no conflict. It other words,
The idea of maintaining public sector character of a bank while
government holds a minority shareholding is an intensified and modified
40

version of “golden share” experiment of UK. The question could still be as
to whether such a mixed ownership of organization, particularly for banks
which are in case generally under intense regulation and supervision.
There are, however, significant element of subjectivity. Governor Jalan
feels that private sectror has greater element of insider model. “Public
sector banks/Fls for example, are more akin to the ‘outsider ,model with
separation of “Ownership’’ and “Management’’.Private sector banks
/NBFCs/co-ops-much more “insider’’modals with families , inter –
connected entities or promoters running
the management”(Jalan 2002).
41

Chapter 7
Best practices of corporate
Governance in Banks
V subbulakshmi
Financial failures like Eron. WorldCom have eroded faith
In the corporate sector generating unprecedented shocks in
The stock markers all over the world. many individual and
Corporate investors have become conservative in their
Investment decisions they demand higher degree of scrutiny
Of a corprate’s financial disclosure and stringent
Disclosure norms to avoid such irreversible and
Irrecoverable scandals in the future . consequently, the board
Rooms are compelled to pay greater attention to their
Relationship with the stakeholders and the transparency of
Their financial statements. Legislative and regulatory issues
Have also been made more stringent to boost investor
Confidence. The audit pocess has also been reviewed
Thoroughly with clear guidedlines the focus on corplorate
Dities and responsibilities. The focus
Historical Context
India had a fairly well developed commercial banking system in existence at
the time of independence in 1947
The Reserve Bank of India (RBI) was established in 1935. While the RBI
became a state-owned institution from January 1,1949, the Banking
Regulation Act was enacted in 1949 provinding a framework for regulation
and supervision of commercial banking activity. The first step towards the
nationalisation of commercial banks was the result of a report
42

(under the aegis of RBI) by the Committee of Direction of ALL India
Rural Credit
Survey (1951 ) which till today is the locus classicus on the subject.
Thus, the Imperial Bank was taken over by the Government and
renamed as the State Bank of India (SBI) on July 1 , 1955 with the
RBI acquiring overriding substantial holding of shares .
A number of erstwhile banks owned by princely states were made
subsidiaries of SBI in 1959.
To meet these concerns , 1967, the Government introduced the concept
of social control in the banking industry. The scheme of social control
was aimed at bringing some changes in the management and
distribution of credit by the commercial banks.
Political compulsion then partially attributed to inadequacies of the
social control , led to the Government of India nationalizing, in 1969, 14
major scheduled commercial banks which had deposits above a cut-off
size. The objective was to serve better the needs of development of the
economy in conformity with national priorities and objectives.
From the fifties a number of exclusively state- owned development
financial institutions (DFIs) were also set up both at the national and
state level, with a lone exception of Industrial Credit and Investment
Corporation of India (ICICI ) which had a minority private share
holding.
Reform Measures
The major challenge of the reform has been to introduce elements of
market incentive as a dominant factor gradually replacing the
administratively coordinated planned actions for development . Such a
paradigm shift has several dimensions , the corporate governance
being one of the important elements. The evolution of corporate
governance in banks, particularly, in PSBs, thus reflects changes in
monetary policy , regulatory environment, and structural
43

transformations and to some extent , on the character of the self -
regulatory organisations functioning in the financial sector
Policy Environment
During the reform period, the policy environment enhanced
competition and provided greater opportunity for exercise of what
may be called genuine corporate element in each bank to replace the
elements of coordinated actions of all entities as a “ joint family” to
fulfill predetermined Plan priorities. The measures taken so far can be
summarized as follows:
First, greater competition has been infused in the banking system by
permitting entry of private sector banks (9 licences since 1993 ),
and liberal licensing of more branches
Foreign banks and the entry of new foreign banks. With the
development of a multi- institutional structure in the financial sector.
Non- bank intermediation has increased, banks have had to improve
efficiency to ensure survival.
Second , the reforms accorded greater flexibility to the banking system
to manage both the pricing and quantity of resources. There has
been a reduction in statutory preemptions to less than a third of
commercial banks resources. Valuation of banks ‘ investments is also
attuned to international best practices so as to appropriately capture
market risks.
Third , the RBI has moved away from micro-regulation to macro-
management . RBI has replaced detailed individual guidelines with
general guidelines and now leaves it to individual banks’ boards to
set their guidelines on credit decisions .
A Regulation Review Authority was established in RBI, whereby any
bank could challenge the need for any regulation or guideline and
the department had to justify the need and usefulness for such
guideline relative to costs of regulation and compliance.
44

Fourth, to strengthen the banking system to cope up with the
changing environment, prudential standards have been imposed in a
progressive manner.
Thus, while banks have greater freedom to take credit decisions,
prudential norms setting out capital adequacy norms, asset classification
, income recognition and provisioning rules, exposure norms, and asset
liability management systems have helped to identify and contain
risks, thereby contributing to greater financial stability.
Fifth ,an appropriate legal institutional , technological and regulatory
framework has been put in place for the development of financial
markets. There is now increased volumes and transparency in the
primary and secondary market operations . Development of the
Government Securities , money and forex markets.
Interest rate channel of monetary policy transmission is acquiring
greater importance as compared with the credit channel.
Importance of Corporate Governance in Banks
Corporate Governance is particularly important for banks
because
1) Banks play a dominant role in fina ncial systems and economic growth.
2) Banks are the main source of finance for a majority of firms as access
of financial markets is subject to compliance with cumbersome
regulatory requirements.
3) They are the main depositories for the economy’s saving.
4) They act as the custodian of thew country’s liquid reserves.
Thus the banking system deserves much attention to build a strong,
reliable
And stable financial system in a country .`
Good governance can be built based on the business practices adopted by
the board of directors and management. Many bank failures in the past
have been attributed to inadequate and inefficient management which
45

enabled banks to accept low quality assets and assume additional risks that
extended beyond the level appropriate for the banks’ capacity. Some of the
key element that are identified to be a part of a good governance system at
the individual bank level`:
1 management with high integrity, adequate and experience;
A comprehensive internal information control system to ensure the
decisions if the bank are collective decision;
Prudent credit appraisal mechanism thereby limiting the risk exposure; and
Effective external and internal audit procedures to establish adherence to
the policies and regulations and no special treatment is allowed on any
particular decision.
Ten Commandments of Corporate Governance
We can enumerate the commandments for ensuring bank
corporate governance.
1) Banks shall realize the times are changing
The issue of corporate governance had not been given the requisite
attention in the past until the advent of some economic and financial crises
in the late ‘90s. Times are changing now, and even smallest banks need to
focus on corporate governance restructuring. This is because of the
apparent lack of integrity and values in the operation some large
corporations like World Com and Enron.
2) Banks shall establish an effective capable and reliable board of
directors
Establishing an effective, capable and reliable board of directors requires
involving well qualified and successful individuals with integrity. This
implies that a majority of banks of board of directors should be truly
46

outside independent directors. Here, “independence” refers to the
individual not working for the bank and he/she not having material
relationship with the bank.
The board should set a long-term strategy, policy and values for the
organization. Nevertheless, the bank should not micromanage the
institution.
3) Banks shall establish a corporate code of ethics for themselves
Corporate ethics and values should be established at the top and should be
used to govern the operations of the company both from a long-term and a
short-term view point.
Unless this exercise is accomplished, executive management cannot
anticipate that the rank and file employees will follow such a code on their
own.
A workable, reliable and such a code should be reviewed annually.
4) Banks shall consider establishing an Office of the Chairman of the
Board
Many banks are already examining this idea of eatablishing Office of the
Chairman of the Board. Such an Office will be made to report to the board
and will act as the board’s eyes and ears on a daily basis in connection
with the functions of the bank.
5) Banks shall have an effective and operating audit committee,
compensation committee and nominating/corporate governance
committee
The audit committee, compensation committee and nominating committee
should be composed of all independent, outside directors of the bank who
operate independently. These committees should have access to attorneys
and consultants paid for by the bank other than the bank’s customary
counsel and consultants. This independence of the committees will ensure
any bias in the internal audit committee’s decisions.
47

6) Banks shall consider the effective board compensation
Fair compensation should be paid to the directors. Their remuneration
should be commensurate with the risks they take. The bank should aim to
appoint a highly qualified director and take appropriate measures to retain
them with the organization as it normally does with other employees.
7) Banks shall require continuing education for directors
The financial services industry is now facing a number or challenges due
to many technology innovations. Therefore, it becomes imperative for the
banks to educate their directors to meet the growing needs of the industry.
Continuing education should be given equal importance along with other
parameters outlined above.
8) Banks shall establish procedures for board succession
The presence of qualified members on the board is a very crucial issue. So
a bank should have a clearly specified set of rules regarding issues of
succession to the board. The bank should pose a question naire as
follows:
a) Does the bank have a mandatory retirement age that is actually
enforced?
b) Does a self appraisal process exist to free the board of the non-
productive
directors?
b) Does the bank have a plan to maintain a fully staffed board of
directors with capable people, no matter what the age is as
it moves forward?
9) Banks shall disclose, disclose and disclose the information
48

Banks will find that disclosure will be quicker and more burdensome than
it was in the past. This may be through quarterly letters to the shareholders
or other types of communication.
10)Banks shall recognize that duty is to established corporate governance
procedures that will serve to enhance shareholder value
The primary object of the board of directory is to maximize the
shareholder’s wealth. The strategy adopted to achive this objective should
now encompass corporate governance procedures and shoud be designed
with long-term value for the shareholder in focus.
Key Elements of Best Practices in Corporate
Governance
The Key elements identified are:
1) A strong independent board of directors,
2) Independent Committees,
3) Charter-based Committees than rule-based,
4) Code of conduct or ethics,
5) Transparent accounting practices,
6) Director orientation program and an ongoing training, and
7) Risk Management,
Steps taken in India to Improve Corporate
Governance in Indian Banks.
A consultative group of Directors of banks and financial institutions was
set up by the Reserve Bank of India to review the supervisory role of the
Boards of banks and financial institutions and to obtain feedback on the
49

functioning of the Boards vis-à-vis compliance, transparency, disclosures,
audit committees, etc.
These recommendations were based on international best practice as
enunciated by the Basel Committee on banking supervision, other
committee and advisory bodies. But suitable amendments were made in
these international standards to suit the Indian scenario.
Recommendations of the Advisory Group
• Directors of all banks both public and private sector banks should
exercise due diligence with respect to their suitability to the post they
hold by way of qualifications and technical expertise.
• The Government shout be guide by certain broad “fit and proper”
norms for the nomination of the Directors. The criteria suggested by
Bank of International Settlements can be adopted as a guideline to
arrive at an appropriate set of norms .
• For assessing integrity and suitability factors such as criminal records,
financial position, civil action undertaken to pursue personal debts,
refusal of admission to or expulsion from profession bodies, sanction
applied by regulation to similar bodies and previous questionable
business practices, etc, should be considered.
• The appointment / nomination of independent / non- executive
directors to the Boards of banks should be taken from a pool of
professional and talented people to be prepared and maintained by
the country’s Central Bank, Reserve Bank of India. Any violation
of the norm should be notified to the RBI.
• In the current context of banking becoming more complex and
knowledge – based , there is an urgent need for making the boards
50

of banks more contemporarily professional by inducting technically
and specially qualified individual.
• While the existing regulation of appointing experts from different
sectors such as agriculture, SSI, etc can be continued , efforts
should be aimed at combining it with the need based
representation of skills such as marketing , technology and systems
, risk management , strategic planning , treasury operations, credit
recovery , etc.
• The independent and non- executive directors should raise critical
questions relating to business strategy , house keeping and internal
control systems and other important aspects of the functioning
of the bank and investor relations in the meeting of the board.
• In the private sector banks where promoter directors may act in
concert , the independent / non- executive directors should provide
effective checks and balances to ensure that the bank does not
build up exposures to entities connected with the promoters or
their associates.
• The remuneration of the directors should be increased to the
comparable levels of international standards to encourage them
towards maintaining integrity in their performing the duties.
• The office of the chairman and the director should be separated
in respect of large sized public sector to bring in more focus in
rendering their duties.
• The information furnished to the board should be adequate and
complete to enable the members of the Board to take
meaningful decisions.
• Uniform code and procedure should be adopted for recording
the proceedings of the Board meetings in banks and financial
institutions.
51

• The board should be informed periodically of the exposures of
a bank to stockbrokers and market- makers and other sensitive
sectors such as real estate etc.
• All banks should give importance to appointing a qualified
Company Secretary as the Secretary to the Board and also
appoint a Compliance Officer for monitoring and reporting
compliance with regulatory and accounting requirements.
• The Audit committee should comprise independent / non-executive
directors and the Executive Directors should only be a
permanent invitee.
• The Chairman of Audit committee need not be necessarily a
Chartered Accountant and can be an eminent finance or banking
professional too as the committee besides accounting issues
takes care of other management issues takes other management
issues also.
• A nomination committee is recommended for appointing
independent / non-executive directors of banks.
• In addition to the above committees, it is also recommended to
have a Committee of the board that would look into the
grievances of the investors and shareholders with the Company
Secretary as the Head.
• The formation and operationalization of the Risk Management
Committees in pursuance of the guidelines issued by the RBI
should be speeded up and their role should strengthened
further.
It is imperative for the government and the RBI to work
collectively to bring out significant changes in the corporate
governance mechanism adopted by banks and other financial
intermediaries . RBI should stay away from appointing its nominees
on the Boards of banks to avoid conflicts of interests.
52

Banks need to have clear cut, well- defined strategies for guiding
their operations and establishing accountability for executing
them . Banks should maintain a high degree of transparency in
regard to disclosure of information.
53

CONCLUSION
Corporate governance thus has become a topic interst to
Many audience including the corporate directors, the central
banks and other regulatory authorities. Like many issues, even
CG has become an interesting issue that attracted public
attention in the wake of corporate scandals like Enron.
Governance issue generally centers around accountability of
the parties involved in decision-making in a bank or any
organization. Liberalization and deregulation, and volatility in
the financial markets are the major factors that have triggered
an interest in the issue of corporate governance. This book in
this context has made an attempt to introduce the reader the
concept, issues and perspectives of corporate governance in
the financial sector in general and banks in particular. This is
the first book in the series giving a brief introduction on the
corporate governance practices in some of the Asian banks and
Indian banks. We welcome the suggestions of the readers to
improve the contents in our future editions.
54

Corporate goverance

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