Special Topics In Banking & Finance

Dr. Karim KobeissiArts, Sciences and Technology University in Lebanon

Chapter 1:Corporate Governance in the Banking System

Corporate Governance - Definition

Corporate governance is the system of rules, practices and processes

(a series of actions taken in order to achieve a particular end) by

which a company is directed and controlled.

Good corporate governance is a key element in improving economic

efficiency.

Conversely, bad corporate governance, particularly in banks, can

damage economic and financial stability. This was demonstrated by

the Asian Crisis 1997.

The Role Of Bad Corporate Governance In The Asian Crisis

Weak corporate governance in Asian banks was one of the key factors in the Asian crisis:

Many banks were controlled by owner-managers and the board of directors played

little role

Banks were often parts of wider conglomerates and used to fund other parts of the

group or the owners (connected lending)

Banks were subject to political influence in their lending decisions

Management was weak and lacked self-responsibility

Growth was more important than return on capital

Risk management was poor

Lack of credit controls and skills

Excessive risk concentrations in individual borrowers and sectors

Excessive funding and currency mismatches ( how a change in the exchange rate

will affect the present discounted value of future income and expenditure

flows).

Why Guidance For Banks?

• Banks have a unique role in the economy (e.g., 6% of

the GDP in Lebanon – Principal lender of the national

economy in both private & public sectors).

• Ensure stability of financial system and prevent worst

consequences of bank failures (e.g., economic crisis).

• Protect public savings.

• Limit government’s potential liabilities.

Basics of Effective Governance

Basics of effective corporate governance are important but may be beyond

supervisory control:

Macro-economic policies

System of business laws

Market integrity and transparency

Accounting standards

Bank’s board of directors should be aware of obstacles to sound banking

governance and take steps within its power to promote effective principles.

Sound Banking Governance Principles 1- Establish strategic objectives and corporate values.

2- Establish clear lines of responsibility and accountability.

3- Ensure that board members are qualified for their positions.

4- Ensure that there is appropriate oversight by senior management.

5- Effectively utilize Internal and external auditors as well as other control functions.

6- Ensure that compensation policies and practices are consistent with the bank’s ethical values, objectives, strategy and control environment.

7- Conduct corporate governance in a transparent manner.

8- Maintain an understanding of the bank’s operational structure: “Know your structure”.

1. Establish strategic objectives and corporate values that are communicated

throughout the banking organisation

Strategic objectives and corporate values Should be established by the board of directors

Corporate culture should foster ethical behaviour

“Tone at the top” (a term that originated in the field of accounting and is used to describe an organization's general ethical climate, as established by its senior management. Having a strong tone at the top is believed by business ethics experts to help prevent fraud and other unethical practices) is important .

Standards should address corruption, self-dealing (the conduct of a trustee that consists of taking advantage of his position in a transaction and acting for his own interests rather than for the interests of the beneficiaries of the trust, corporate shareholders, or his clients) and other unethical or illegal behaviour .

“Whistleblowers”: Employees should be encouraged to raise concerns about illegal or unethical practices to the board or an independent committee without fear of revenge.

Potential trouble situations

Lending to officers, employees or directors where allowed by national law

Consistent with market terms or terms offered to all employees

Limited to certain types of loans

Reports should be provided to the board

Subject to review by auditors and supervisors

Preferential treatment to related parties

Conflicts of interest

Addressing conflicts of interest

Potential conflicts of interest arising from activities of the bank should be:

Identified

Prevented or appropriately managed

Information barriers between different units

Separate reporting lines and internal controls

Clear, fair, accurate information to customers

Appropriately disclosed

2. Establish clear lines of responsibility and accountability

Board and senior management

• Unclear lines of responsibility can make problems worse

• The board of directors should:

– Define authorities and key responsibilities

– Oversee management actions

• Senior management should:

– Delegate responsibilities to staff and promote accountability

– Be responsible to the board for the performance of the bank

Accountability within banking groups

• Parent board and senior management:

– Set general strategies and policies for the group

– Determining governance structure for subsidiaries that best contributes to

effective oversight

– Be aware of risks throughout the group

– Integrate and coordinate governance structures

• Bank board and senior management:

– Responsible for governance of bank

– Reliability of bank, protection of depositors, compliance with laws and

regulations

– Intra-group outsourcing (e.g. internal audit, risk management) do not

eliminate bank board oversight

– Has ultimate responsibility for corrective action at the bank

3. Ensure that board members are qualified for their positions, have a clear understanding of their role in corporate governance and are able to exercise sound independent judgment about the affairs of the bank

The board should… Understand supervision role and duties to bank and shareholders. Avoid conflicts of interest. Have sufficient time and energy to fulfill responsibilities. Maintain collective expertise (experts in different fields) as bank grows. Implement targeted board training as necessary. Assess the effectiveness of its own governance practices. Ensure bank has an appropriate plan for executive succession. Question and receive information from senior management. Provide sound and objective advice. Do not participate in day-to-day management. Exercise due diligence (investigation of a business or person prior to signing a

contract) in hiring external auditors.

Independent directors

Board should have adequate number of independent directors Independence = ability to exercise objective judgment Helpful if not members of bank management Especially important in certain areas:

Ensuring integrity of reporting Nomination of key executives Board and key executive compensation

4. Ensure that there is appropriate oversight by senior management

Senior management responsibilities

• Should have necessary skills to manage business and exercise

appropriate control

• Supervise line managers consistent with the board of directors policies

• Critical role: Establishing system of internal controls

• Situations to avoid:

– Inappropriate involvement in business line decisions

– Managing areas without skills or knowledge

– Inability to control “star” employees

5. Effectively utilize Internal and external auditors as well as other control functions

Auditors and other control functions

• Should be: – Independent– Competent– Qualified

• Identify problems in risk management & internal control• Ensure financial statements are accurate

Enhancing audit & control effectiveness

• Recognise importance and promote throughout bank• Limit non-audit services• Consider rotation of audit firm or lead audit partner• Utilise audit findings and require timely correction• Report to the board or audit committee• External auditors review internal controls• Independent directors meet in the absence of bank management

with external auditor and heads of internal audit, legal functions

6- Ensure that compensation policies and practices are consistent with the bank’s ethical values, objectives, strategy and control environment

Board and key executive compensation

• Compensation should be consistent with:– Long-term business objectives and strategy– Corporate culture– Control environment

• Should not overly depend on short-term performance• Board (or independent committee) should approve compensation• Policies re: trading bank stock and granting/re-pricing stock options

7- Conduct corporate governance in a transparent manner.

Transparent Governance

• Necessary for shareholders (owners of shares in a company), other stakeholders (parties that have interests in an enterprise or a project) and market participants to monitor and hold accountable the board and senior management

• Need information on corporate structure and objectives• Complex cross-shareholdings (situation in which one publicly-

traded company owns shares in another publicly-traded company) can obstruct transparency

• At a minimum, all banks should make disclosures to supervisors

What Should Be Disclosed?

Disclosure on public website or in annual report:• Board and senior management structure• Organisational structure (including ownership)• Code of business conduct and/or ethics• Full annual financial statement with supporting notes and

schedules

8. Maintain an understanding of the bank’s operational structure, including operating in

jurisdictions, or through structures, that impede transparency (i.e. “know your

structure”)

Operational Structure

• Some bank operations may lack or weaken transparency– Particular authorities (e.g. in some abroad centres)– Complex structures (e.g. special purpose vehicles or

corporate trusts)• Banks may provide services or establish untransparent

structures for clients• Often legitimate and appropriate business purposes

Supervisory concerns

• The use or sale of opaque structures/products may:

– Pose potentially significant financial, legal and reputational

risks

– Obstruct board and senior management oversight

– Delay effective banking supervision

• Risks should be appropriately assessed and managed (e.g., The

need for such activities should be regularly assessed and

subject to enhanced audit procedures )

Supervisory Questions

Does the board exercise effective oversight? Are controls to detect and mitigate conflicts of interest adequate? Are internal controls properly implemented (as opposed to being written

down but not operational)? Do internal and external audit functions conduct independent and effective

reviews? Are major shareholders, directors and managers “fit and proper”?

Will an individual’s skills and experience contribute to bank safety and soundness?

Does criminal or regulatory record make a person unfit? Is a group structure managed in such a way as to negatively impact

management of the bank?

Basel Accords - BackgroundIn late 1974, the G-10 nations (Belgium, Canada, France, Italy, Japan,

Netherlands, United Kingdom, United States, Germany and Sweden)

formed the Basel Committee on Banking Supervision - BCBS, under

the sponsorship of the Bank for International Settlements (BIS)

located in Basel, Switzerland.

The Committee is not a classical multilateral organization, in part

because it has no founding treaty. BCBS does not issue obligatory

regulation; rather, it functions as an informal forum in which policy

solutions and standards are developed.

BCBS - Objectives

The main objectives of the Basel Committee on

Banking Supervision (BCBS) include:

1) To enhance understanding of key supervisory

issues and improve the quality of banking

supervision worldwide.

2) To encourage convergence toward common

approaches and standards.

Basel I – The Core Principles In 1988, the BCBS published a broad supervisory standards

and guidelines (25 Basic Principles) of best practice in banking supervision . These principles are also known as the Basel I accord, and were enforced by law in the Group of Ten (G-10) countries in 1992 :

• Preconditions for effective supervision (1)• Licensing and structure (2-5)• Prudential regulations and requirements (6-15)• Methods of ongoing supervision (16-20)• Information requirements (21)• Formal powers of supervisors (22)• Cross-border banking (23-25)

EVOLUTION OF THE WORK OF THE BASEL COMMITTEE ON BANKING SUPERVISION

A New Capital Adequacy Framework - Basel II Accord

A new set of rules known as Basel II was developed in 2004 with the

intent to surpass the Basel I accord. Basel II was criticized by some for

allowing banks to take on additional types of credit risk, which was

considered part of the cause of the US subprime (relating to loan

arrangements for borrowers with a poor credit history, typically

having unfavourable conditions such as high interest rates) financial

crisis that started in 2008. In fact, the Federal Bank in the United

States took the position of requiring a bank to follow the set of rules

(Basel I or Basel II) giving the more conservative approach for the

bank.

Basel III Accord

Basel III was developed in response to the 2008

financial crisis; it does not surpass either Basel I or

II, but focuses on different issues primarily related

to the risk of a bank run.

EVOLUTION OF THE WORK OF THE BASEL COMMITTEE ON BANKING SUPERVISION