the governance of banks in transition economies kazakhstan ...kazkommertsbank jsc (‘kazkom’):...

The governance of banks in transition economies Kazakhstan country report

January 2011

Kazakhstan Country Report – January 2011 PAGE 2 of 29

Table of content

Foreword .......................................................................................................................................... 3 A. Introduction and overview of the banking system in Kazakhstan .................................................. 4

1) Methodology ....................................................................................................................... 4

2) Overview of the corporate governance of banks in Kazakhstan ...................................... 4 B. Executive summary ...................................................................................................................... 7

1) Legal framework ................................................................................................................. 7

2) Supervisory practice............................................................................................................ 8

3) Bank practice ....................................................................................................................... 8

4) Key recommendations ........................................................................................................ 9

5) Overall assessment of bank governance quality in Kazakhstan ..................................... 11 C. Analysis of the strengths and weaknesses of the corporate governance of banks in Kazakhstan .. 14

1) The strategic and governance role of the board ............................................................. 14

2) Composition and functioning of the board ...................................................................... 16

3) Risk governance ................................................................................................................ 22

4) Internal control ................................................................................................................. 24

5) Incentives and compensation ........................................................................................... 27

6) Transparency to the market and regulators .................................................................... 28

This Report does not constitute legal advice. Readers are advised to seek appropriate legal advice before entering into any transaction, making any determination or taking any action related to matters discussed herein. The content of this Report is copyrighted. The assessments and views expressed in the Report are not necessarily those of the EBRD. All assessments and data in the Report are based on information gathered in the course of 2010.

For information or comments please contact Gian Piero Cigna at [email protected]

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The team is grateful for the assistance provided by all parties interviewed. In particular, the team would like to acknowledge the precious assistance offered by the law firms Grata (http://www.gratanet.com) and Chadbourne & Parke (http://www.chadbourne.com).

mailto:[email protected]

http://www.gratanet.com/

http://www.chadbourne.com/


Foreword

1. In July 2010, the Legal Transition Team of the EBRD launched a comparative assessment of the corporate governance of banks in its countries of operations. The overall objective of the assessment is to inform and support the EBRD’s policy dialogue with authorities with a view to generating further commitment to improve the corporate governance of banks in EBRD countries of operations. The assessment aims at providing the EBRD with an overview of the legal and regulatory framework governing the corporate governance of banks and how diligently the various rules and best practice guidelines are implemented.

2. The assessment focuses mostly on internal corporate governance arrangements in banks, particularly the role and composition of boards. It analyses the legal and regulatory framework; its implementation by supervisors; and the practices developed by the systemically important banks in each country. The transparency of governance arrangements to the supervisory authority and the markets is also reviewed. While the assessment analyses banks and their boards, and considers ownership structure and patterns in the banking sector, broader governance issues covered in the OECD principles such as shareholder and stakeholder rights and responsibilities as well as equity market issues are not dealt with in any detail.

3. To enhance the EBRD’s understanding of the corporate governance of banks in countries of operations, countries reviewed are subjectively rated. For this purpose, the legal framework, supervisory practice and banking practice are given an overall score in the executive summary section of each Country Report. In addition, the performance of countries in the key areas mapped out in the EBRD checklist is also rated and included in the executive summary section of each Country Report. The rating approach is detailed in the box below.

Rating

“Strong to very strong” - The corporate governance framework / practices of supervisory authorities /

practices of banks are fit for purpose and are close to best practice.

“Moderately strong” - Most parts of the corporate governance framework / practices of supervisory

authorities / practices of banks are adequate but further reform is needed

“Weak” - The corporate governance framework / practices of supervisory authorities / practices of

banks contain some elements of good practice but overall the system is in need of reform

“Very weak” - The corporate governance framework / practices of supervisory authorities / practices

of banks contain significant risks and are in need of significant reform

4. This Country Report is divided into three sections: (A) Methodology and overview of the banking system; (B) Executive summary; (C) Analysis of key strengths and weaknesses of the corporate governance of banks and policy recommendations where appropriate.


A. Introduction and overview of the banking system in Kazakhstan

1) Methodology

5. The analysis and recommendations contained in this report are based on research carried out by the EBRD and responses to written questionnaires sent to two Kazakh law firms; the Kazakh supervisory authority (the Agency of the Republic of Kazakhstan on Regulation and Supervision of Financial Market and Financial Organizations (hereafter the ‘Kazakh FSA’); and three of the five largest banks of the country. Responses to the questionnaires were complemented by face-to-face interviews carried out in Almaty in November 2010 during which the EBRD assessment team met with respondents to the questionnaires as well as representatives of the Banking Association of Kazakhstan.

6. Based on a best practice assessment check list, the questionnaires and interviews inquired about the legal and regulatory framework on bank governance, supervisory practice and the practice of three among the largest banks in Kazakhstan (‘the banks reviewed’). According to information disclosed in 2009 annual reports, the three largest banks in Kazakhstan, measured by their share of the total assets of the country’s banking system were Kazkommertsbank JSC (20.35 percent); Halyk Bank of Kazakhstan JSC (17.21 percent); and BTA Bank JSC (17.06 percent). Together, they control 54.63 percent of the total net assets of the Kazakh banking system.

2) Overview of the corporate governance of banks in Kazakhstan

7. According to the EBRD transition report1, the banking system of Kazakhstan was severely affected by the sudden stop of external financing in the second half of 2007, with several banks unable to meet their obligations having to be nationalised. Restructuring of bank debt and the cleaning of balance sheets have continued over the past year, but very substantial challenges remain. In May 2010 external creditors of BTA Bank JSC, a major bank now majority-owned by the sovereign wealth fund Samruk-Kazynai (hereafter ‘SK’), voted in favour of restructuring more than US$ 12 billion of debt. Earlier, Alliance Bank restructured over US$ four billion in external obligations and negotiations are under way among a number of smaller banks, including Temir Bank and Astana Finance.

8. The aggregate capital base of the banking sector remains low, but non-performing loans (estimated to stand at 26 percent of the total loans on a 90-day-overdue basis) have been adequately provisioned. To avoid an excessive reliance on external financing, a major factor in the severity of the banking crisis within Kazakhstan, the authorities have implemented restrictions on overseas borrowing by banks and raised provisioning requirements on foreign currency denominated loans to unhedged borrowers. In addition the authorities are expected to impose a maximum loan-to-deposit ratio of 150 percent. Although loan-to-deposit ratios have been falling steadily, in many banks they continue to exceed this threshold.

1 European Bank for reconstruction and development, 2010. Transition Report 2010, Kazakhstan, [internet] available

at http://www.ebrd.com/downloads/research/transition/assessments/kazakhstan.pdf

http://www.ebrd.com/downloads/research/transition/assessments/kazakhstan.pdf


9. More than US$ 70 billion (or 50 percent of GDP) worth of assets across various sectors of the economy, including the financial sector, are now controlled by the national welfare fund Samruk-Kazyna. The involvement of the government in the economy through Samruk-Kazyna is likely to remain high as the crisis-related fiscal stimulus package blends into the 2010-15 industrialisation plan, which encompasses investment in various large infrastructure and industrial projects. The plan will be partially financed by resources attracted from China (over US$ 10 billion) and a number of multilateral development banks.

10. According to the Kazakh FSA, as of October 2010 the banking sector in Kazakhstan consisted of 38 banks. One bank, the Housing Construction Savings Bank of Kazakhstan JSC, is fully owned by the state. The Box below briefly describes the ownership structure of the five largest banks in Kazakhstan measured by their share of the total assets of the country’s banking system (as described in 2009 annual reports).

Kazkommertsbank JSC (‘Kazkom’):

Kazkom is the largest bank with 22.3 percent of the total assets of the Kazakh banking system. Kazkom has common and preferred shares and debt securities listed on the Kazakhstan Stock Exchange (‘KASE’). According to the exchange, as of 1 January 2010 the capitalization of Kazkom stood at KZT 550,646 million which represented approximately 6.4 percent of stock market capitalisation on KASE. Kazkom was also the first CIS bank to complete an IPO in GDR form on the London Stock Exchange in November 2006, in a deal totalling $845 million.

According to the consolidated statements of the bank, the ownership structure breaks down as follows: Central Asian Investment Company (‘CAIC’) (31.06 percent shares under control)2; CAIC (23.72 percent shares owned); Alnair Capital Holding (28.565 percent); Samruk-Kazyna National Welfare Fund (21.26 percent); EBRD (9.77 percent); Mr. N.S. Subkhanberdin (9.32 percent); Other (7.365 percent). According to the annual report 2009, as of 31 December 2009, Subkhanberdin N.S. the bank’s chairman, owned 30.01 percent of the ordinary share capital of the Bank through direct and indirect ownership as a result of his holdings in CAIC.

Kazkom has a number of subsidiaries: LLP Moskommertsbank (Moscow); OJSC Kazkommertsbank Kyrgyzstan; and other subsidiaries in Kazakhstan in the insurance, securities and pensions sectors.

Halyk Bank of Kazakhstan (‘Halyk Bank’):

Halyk bank is the second largest bank with 17.5 percent of the total assets of the Kazakh banking system. Shares of Halyk Bank have been listed on the KASE since 1998 and common shares in the form of GDRs on the London Stock Exchange since December 2006. According to the KASE annual report 2009, the stock market capitalization of Halyk Bank as of 1 January 2010 was KZT 473,267.4 million, or 5.5 percent of the aggregate stock market capitalisation.

According to the information published on the bank’s website, its current shareholders’ structure is as follows: Holding Group Almex JSC (54.23 percent); Samruk-Kazyna (20.91 percent); GDR holders (20.04 percent); and others (“including pension funds and individuals”) (4.69 percent).

BTA Bank:

BTA Bank is the third largest bank in Kazakhstan with 17.06 percent of the total assets of the Kazakh banking system. According to disclosures on BTA Bank’s website, the current major shareholder is the Government of Kazakhstan which owns 81.48 percent of the share capital through SK. The “Central Securities Depository” (nominee holder) owns 15.59 percent of the share capital. The EBRD, IFC, and East Capital are also shareholders “with a share of less than 5 percent”.

BTA was a victim of the financial crisis which revealed significant and allegedly fraudulent related party lending. As a result of the crisis the bank was essentially taken over by the government.

2 According to the Consolidated Financial Statements for the Years Ended 31 December 2009, 2008 and 2007, p.20,

“JSC Central-Asian Investment Company (“CAIC”) is one of the entities through which the Directors and Management Board members own shares of the Bank.”


Bank CenterCredit JSC:

Bank CenterCredit is the fourth largest bank with 10.0 percent of the total assets of the Kazakh banking system. According to disclosures on Bank CenterCredit’s website the shareholders’ structure of the bank breaks down as follows: Bakhytbek R. Baiseitov (chairman of the board) (25.1 percent); Kookmin Bank Co.Ltd (41.9 percent); IFC (10.0 percent); others (23.0 percent). The Bank's common shares are listed on the "A" List of KASE.

ATF Bank:

ATF Bank is the fifth largest bank with 9.3 percent of the total assets of the Kazakh banking system. According to information available on ATF Bank’s website, Unicredit Bank Austria AG currently owns 99.7 percent of the voting share capital. ATFBank had shares and debt securities listed on KASE.

11. The corporate governance of banks in Kazakhstan is regulated by the following key laws and regulations.

The Law of the Republic of Kazakhstan on Joint-Stock Companies as amended (‘Law on JSC’) (Adopted on 13 May 2003): The law regulates the formation, organisation and dissolution of joint stock companies.

Law on banks and banking activities in the Republic of Kazakhstan No. 2444 as amended (Adopted on 31 of August 1995): The law regulates the activities of second tier banks.

Law No. 474 concerning the state regulation and supervision of financial market and financial organisation (Adopted on 4 July 2003): Regulates the powers and of the Kazakh FSA.

Decree No.359 "Instruction on requirements to risk management and internal control systems in the second level banks” (‘Decree 359’): Adopted by the Council of the FSA on 30 September 2005 (last amended on 29 December 2009). The Decree regulates the organisation or risk management and internal control systems in banks.

Listing Rules of the Kazakhstan Stock Exchange (Adopted in November 2009 as Annex L1 to Rules of Stock Exchange Securities Trading): The rules apply to companies admitted to trading on the Kazakhstan Stock Exchange.

12. The Parliament is currently considering changes to the legal framework on the corporate governance of banks. The major changes foreseen are (i) strengthening liabilities for bank directors and (ii) changing the holding structure of banking conglomerates. These changes are in part answers to two major scandals that threatened two systemically important banks and forced a government bailout. Both significant banking collapses (BTA Bank and Alliance Bank) seem to have been largely the result of related party lending within financial industrial groups. In response, the Kazakh FSA and the Kazakh National Bank are proposing that banks should not be allowed to own non-banking affiliates and those holding companies that own banks should not be allowed to own any non-financial companies. Banks seem to be currently lobbying to ensure that the proposed ban will not result in the prohibition of debt-to-equity swaps in the context of post-crisis widespread restructuring of Kazakh enterprises outside the natural resources sector.


B. Executive summary

1) Legal framework

Key strengths

13. Kazakhstan has developed the main legal tools for regulating the corporate governance of banks. The country has adopted a detailed company law and a banking law that regulates licensing and activities of banks. With the adoption of Decree 359 in 2005, the country has also established a comprehensive regulatory framework on internal control and risk management in financial organisations.

Key weaknesses

14. In what seems to be a common trait in many post-Soviet era jurisdictions, company law adopts a middle way between unitary and two-tier board structures. Unlike in typical unitary board systems, boards are not given a broad mandate to manage their company coupled with the power to delegate responsibility as they see fit. Nor are boards just a supervisory body with all executive powers assigned to a management body. Instead, the law “micromanages” the distribution of power between boards and management. As a result, broadly defined and enforceable director duties of loyalty and care do not seem to exist in Kazakh law. Instead, a box ticking approach at board and senior management level seems to be the predominant response to multiple, narrowly defined “duties” of boards and their directors.

15. While Decree 359 contains very detailed requirements on various risk reports and the structure and duties of control functions, it does not require the establishment of audit committees of the board, independent from major shareholders and management, with significant responsibilities for controlling conflicts of interests. This seems to be a major regulatory gap in an environment dominated by major shareholders with many other business interests. The crisis revealed a business environment rife with sometimes abusive related party transactions that the detailed control requirements of Decree 359 failed to contain.

16. In view of the above, current proposals aimed at enhancing ownership transparency in order to enhance the control of related party transactions are welcome. So is the proposal to disallow bank holding companies from controlling, directly or indirectly, non-financial companies and assets.


2) Supervisory practice

Key strengths

17. The rudiments of a supervisory framework have been established to oversee the activities of financial institutions. The Kazakh FSA is the authority responsible for granting and withdrawing banking licences, adopting banking regulation and supervising regulated entities. The supervisory framework also includes an automated approval regime for directors and senior management specifically adapted to the particular circumstances of the country. This ensures some measure of objectivity to the approval process while circumventing to some extent the lack of experience and alleged corruption of supervisory authorities.

Key weaknesses

18. The carving out of financial sector regulation and supervisory responsibilities between the Kazakh FSA and the National Bank of Kazakhstan which occurred in January 2004 does not seem to have worked perfectly. It appears from our research and responses to interviews that the Kazakh FSA has limited understanding of its banking sector and limited political clout to resist the powerful local interests that dominate the banking sector. The collapse of two systemically important banks in the recent past and continued weak compliance with the very detailed regulatory requirements on internal control alludes to a supervisor that lacks credibility. In contrast, the National Bank seems to be more respected as an institution capable of taking an independent view of regulated entities.

19. Our discussions also indicated limited expectations from the judicial system as an enforcer of governance related abuses.

3) Bank practice

Key strengths

20. Overall, the practices of banks are superior to the practice of the supervisory authority and seem to go beyond the requirements of the legal framework that regulates the governance of banks. Responses to questionnaires and interviews indicate that the four banks reviewed largely follow best practice with regards to board composition and board structure. The boards of these banks also seem to have a significant role in shaping the strategy of their banks. This can be explained by the fact that two of the four banks reviewed are listed on the London Stock Exchange and one of them is also the subsidiary of one of Europe’s largest banking group: before its acquisition, the bank’s practices were reportedly questionable and its credit portfolio subpar. In addition, it was reported that best practice changes to the governance of some of these banks only happened recently as a result of the financial crisis. One of the four banks reviewed failed—largely as a result of bad practices and very weak governance—and was bailed out by government.

21. There is no indication that the very significant role of the government via Samruk-Kazyna is used to enhance governance in the most significant banks. In fact, as regards two of the four


banks reviewed, the government seems to have relinquished its powers as a shareholder to the benefit of the majority shareholder.

Key weaknesses

22. There are several weaknesses in the way the boards of the four banks reviewed work. To begin with, the long list of board “duties” described in company law and banking regulation translates into loaded agendas for these boards and a degree of rubberstamping that might be crowding out strategic reflection. Another issue is that committees are largely perceived as control mechanisms parallel to the board. Their composition often includes executives who could be conflicted and outsiders whose presence as members could compromise confidentiality (and therefore limit the probity of committees). Information flows between boards and committees seems to be sub-optimal and there seems to be plenty of duplication in their functions. This makes board committees an additional “burden” on the schedule of board members rather than a welcome support to the board’s overloaded agenda.

23. We also found the overall approach to risk oversight to be inconsistent. To begin with, not all four banks reviewed seem to have capable chief risk officers with sufficient “gravitas” within their organisations. Also, the board’s approach to setting the risk appetite in their respective institution appears to consist solely of regulatory–driven credit and market risk limits. These limits change regularly upon management’s request. This is in fact a bottom-up risk appetite approach, driven by front office credit officers. In order to avoid the mistakes of the recent past, boards need to have a more thorough discussion of forward looking risk issues and set clear boundaries that management should respect. This seems especially important in a small economy like Kazakhstan’s with significant concentration of economic interests. Without top down risk appetite boundaries to which the board is committed, credit will always be driven by the power of local economic interests over credit officers and committees.

24. Finally, directors do not seem to receive proper induction upon appointment and boards do not take the time to perform an evaluation of their own activities. Both of these practices are considered important, especially in the banking sector whose complexity requires additional board and director effectiveness.

4) Key recommendations

25. The following box is a summary of the recommendations contained in Section (C) below which aim to address some of the weaknesses identified in this Country Report. The purpose of these recommendations is to assist the EBRD in identifying priority areas for policy dialogue.

Legal framework

1. The list of reserved powers of the board included in the Law on JSCs should ideally be limited to high level strategic and operational matters. Banks should have more flexibility to determine which decision should be delegated to the management board.

2. The legal framework on director duties should be enhanced to include a duty of care and loyalty for directors.


3. The scope of the approval regime should be extended to include key control and client-facing functions.

4. Banking regulation should require the establishment of audit committees in systemically important banks. In addition to supporting the board in ensuring the integrity of financial statements and the effectiveness of the internal control systems, audit committees should ensure the systematic and independent review of significant conflicts of interests between banks, their boards, their directors and affiliates, including related party transactions. The views of the audit committee on proposed related party transactions should also be communicated to the Kazakh FSA.

5. Audit committees should be composed exclusively of non-executive directors independent from management and controlling shareholders. More generally, as discussed above with regards to all board committees, it should be very clear that audit committees are responsible for supporting and advising the board. As such, chairmen of audit committees should be required to report on committee discussions during all board meetings. The agenda and minutes of committees should also be available to boards.

6. Banking regulation should require systemically important banks to disclose the information necessary to enable the market and other stakeholders to understand their management, governance, financial performance and ownership structure, through annual reports or on the corporate website.

7. In addition, the following information should be communicated to the Kazakh FSA on an annual basis: an operating and financial review; a report on risk along the lines required by Basel pillar III enabling a better assessment of their risk profile and their capital adequacy; and a corporate governance report.

Supervisory practice

8. The FSA should require the boards of the four banks reviewed to adopt a forward looking statement on risk appetite. The risk appetite should be communicated to the FSA.

9. The FSA should require more transparency with regards to executive remuneration in line with the recommendations of the G20.

Bank practice

10. Board committees should not contain outside members who are not members of the board. If outside advice is needed on technical matters, it should be provided to the committee on a consulting basis.

11. The board secretary should be a senior official. He/she should also be responsible for supporting board committees to foster consistency and cohesion between the board and its committees.

12. The boards of the four banks reviewed should have in place a programme of induction and continuous learning and/or training for directors.

13. Boards should carry out regular board evaluations to assess their effectiveness.

14. Banks with low levels of financial industry expertise should consider establishing board risk committees.


5) Overall assessment of bank governance quality in Kazakhstan

26. The following table provides a preliminary rating of Kazakhstan’s performance in the key governance areas mapped out in the EBRD best practice assessment checklist. Rating in this table is subjective and based on the overall assessment of the strengths and weaknesses of the legal framework, supervisory practice and the practice of banks as discussed in section C below.

Issues Score 3

The strategic and governance role of the board

Strategic role of the board

Do boards have an active role in developing and approving the strategic objectives and the budget of their banks?

Strong

Do boards effectively review and evaluate management performance against agreed budgetary targets?

Strong

Governance role of the board

Do boards effectively shape the governance framework and corporate values throughout their organisation?

Moderately strong

Are boards of subsidiaries in a position to effectively control the operation of their subsidiaries? Moderately

strong

Is there adequate transfer of good practice between parents and subsidiaries? Strong

Board composition and functioning

Size, composition and qualification

Is the size of boards adequate to meet the requirements of their business? Moderately

strong

Are directors qualified for their position? Moderately

strong

Is the board independent from management and controlling shareholders? Moderately

strong

Are the duties of directors to their banks, shareholders and stakeholders clearly set out? Very weak

Is there adequate balance of power between individuals within boards and are there adequate checks to maintain the balance?

Moderately strong

Do board chairs possess relevant banking and/or financial industry experience and a track records of successful leadership?

Moderately strong

Do current tenure patterns of board directors suggest a high level of engagement and independence?

Weak

Do boards provide adequate induction and professional development to their members? Very weak

3 Where: “Strong to very strong” - The corporate governance framework / practices of supervisory authorities / practices of banks are fit for purpose and are close to best practice. “Moderately strong” - Most parts of the corporate governance framework / practices of supervisory authorities / practices of banks are adequate but further reform is needed “Weak” - The corporate governance framework / practices of supervisory authorities / practices of banks contain some elements of good practice but overall the system is in need of reform “Very weak” - The corporate governance framework / practices of supervisory authorities / practices of banks contain significant risks and are in need of significant reform.


Issues Score 3

Nomination committees

Is director succession and nomination a transparent process? Very weak

Functioning and evaluation

Are the responsibilities, authorities, and terms of reference of boards and board committees clearly defined and documented?

Moderately strong

Do boards function in ways that encourage informed contribution and constructive challenge by all directors?

Weak

Do boards meet regularly? Weak

Are boards and board committees supported by a senior company secretary? Very weak

Do boards evaluate their performance and discuss the outcome of such evaluation? Very weak

Risk governance

Risk governance framework

Are boards and their risk committees involved in setting the risk appetite and monitoring the risk profile of banks?

Weak

Do banks appoint and empower senior chief risk officers? Moderately

strong

Do senior executives have an integrated firm-wide perspective on risk? Moderately

strong

Risk committees

Are boards in a position to effectively review risk management? Moderately

strong

Internal Control

Internal control framework

Does the organisational structure of banks include clearly defined and segregated duties for key officers and effective delegation of authority?

Moderately strong

Are there enough check s and balances to ensure the independence and integrity of financial reporting?

Moderately strong

Are conflicts of interest including related party transactions effectively managed? Very weak

Is external auditor independence upheld by boards and their audit committees? Moderately

strong

Have banks established effective internal audit departments? Moderately

strong

Do banks establish effective compliance departments to ensure that they comply with regulatory obligations?

Moderately strong

Do boards and their audit committees effectively oversee and regularly review the effectiveness of the internal control systems?

Moderately strong

Audit committee

Do boards establish audit committees? Moderately

strong

Are audit committees fully independent? Moderately

strong

Do audit committees include at least one member with substantial auditing or accounting experience?

Moderately strong


Issues Score 3

Incentives and compensation

Remuneration policy

Do boards and their remuneration committees effectively shape the compensation system of their banks?

Moderately strong

Is remuneration meritocratic and linked to firm and individual performance? Weak

Is senior executive compensation aligned with prudent risk management? Moderately

strong

Remuneration committee

Do boards establish remuneration committees? Moderately

strong

Are remuneration committees independent from management? Moderately

strong

Transparency to the market and regulators

Financial statements

Is IFRS required by law or regulation? Weak

Corporate governance

Do banks report regularly on corporate governance matters? Weak

Do banks publish key governance information on their website? Weak

Is disclosure proportionate to size, complexity, ownership structure and risk profile of banks? Weak

Transparency to regulators

Can the supervisory authority obtain information about ultimate ownership and other corporate governance matters?

Very weak


C. Analysis of the strengths and weaknesses of the corporate governance of banks in Kazakhstan

1) The strategic and governance role of the board

Key strengths

Legal framework

27. Decree 359 ascribes to boards explicit responsibility for approving the long-term strategy and annual budgets of their banks. Boards also have responsibility for overseeing and assessing management performance against agreed targets.

28. The Law on JSCs contains a set of reserved powers for the board that cannot be delegated to management. With regards to the strategic and governance role of the board, these include high level decisions such as major transactions, financing decisions, appointment of members of the executive body, and the approval of documents regulating internal activities of the company.

Bank practice

29. Responses to questionnaires and interviews indicate that, in compliance with banking regulation, three out of the four banks reviewed are in control of strategy and approve the multiyear business plan. Bank strategies also seem to be well communicated within their organisation and externally to the market. In one respondent bank, the board is increasing its capacity to shape strategic objectives by adopting best practice processes.

“Our board is planning the organisation of a strategy meeting to determine the bank’s short and medium term strategy. The board and the management board will jointly define the principles on which the management board shall be required to develop the strategy. This will be submitted to the board for approval.”

30. The boards of the four banks reviewed also seem to participate in the annual budget setting process. In two respondent banks, the boards discuss budgets prior to approval and approve final budgets. They also receive quarterly reports on variances in the implementation of the budget.

31. With regards to the governance role of the board, responses to questionnaires and interviews indicate that at least two of the four banks reviewed have adopted corporate governance codes outlining their system of governance. These codes were also approved by the general meeting of the two banks. At least one respondent bank also reported using a published corporate governance best practice code as a code of reference: the code of reference is the Code of Corporate Governance approved by the Council of Issuers and by the Council of Association of Financiers of Kazakhstan in 2005.

32. Responses to questionnaires and interviews also indicate that the four banks reviewed have adopted codes of conduct and ethics. In one respondent bank, the code of conduct was also approved by the general meeting.


33. Where the local board is controlled by a multinational group, one respondent bank confirmed that its local board systematically transposes decisions of the (multinational) group to make sure that they become policies of the local bank. This is, in principle, a good way to ensure that global best practice is effectively transplanted without undermining local regulatory requirements. There are also regular audits of group entities by the group internal function.

34. Responses to questionnaires and interviews indicate that the boards of the four banks reviewed are responsible for selecting and replacing members of the management board. In one respondent bank, the board is also responsible for setting performance objectives for senior management and reviewing these annually.

Key weaknesses

Legal framework:

35. In most OECD jurisdictions, unitary boards are responsible for managing the company. One of the most important responsibilities that they have is to strike the right balance between delegating authority to management and retaining authority at board level. In contrast, the Law on JSCs as well as banking regulation tend to “micromanage” the distribution of authority and responsibility between the board and management, adopting a typical post-Soviet legislative approach. Instead of letting bank boards distribute authority to management (i.e. the management board) as they see fit, they contain long lists of distribution of authority to each body.

36. In the same vein, the law requires board approval for too many operational decisions and the extent to which these responsibilities are delegated in practice is not clear. For example, the Law on JSCs makes the board responsible for adopting decisions regarding the formation and closure of the company’s branches and representative offices as well as the company’s participation in the creation and activities of other organisations. It is generally accepted that boards which are involved in operational matters often find themselves with less time available for discussions of strategy. Likewise, Boards that are suffering from ‘information overload’ regarding operational matters will also find it harder to concentrate on the major strategic issues.

Bank practice

37. Responses to questionnaires indicate that not all the boards of the four banks reviewed are in control of strategy. At least one respondent bank indicated that its board was not responsible for approving the multiyear business plan and had not adopted written policy for strategy development and approval.

38. Where the local board is controlled by a multinational group, responses to questionnaires and interviews indicate that local boards do not systematically include local non-executive directors non-affiliated to ensure that both the group perspectives and local Kazakh perspectives are represented. One respondent bank confirmed that while its board is composed of a mix of executives or directors from the group as well as independent directors non-affiliated with the group, it does not include a director with expert knowledge of the Kazakh market and banking system.


Recommendations

Legal framework

39. The list of reserved powers of the board included in the Law on JSCs should ideally be limited to high level strategic and operational matters. Banks should have more flexibility to determine which decision should be delegated to the management board.

2) Composition and functioning of the board

Key strengths

Legal framework

40. Banking regulation includes fit and proper requirements for board directors. These cover members of the board, members of the management board, the chief accountant and other officers of the bank who coordinate and/or control the activities of bank units and have the right of signature (‘approved persons’). The fit and proper requirements are comprehensive and cover the probity, reputation, and competence of approved persons. With regards to competence, banking regulation might even seem overly restrictive as it provides that an approved person should possess “experience in the international financial organizations (…) and (or) working experience in sphere of rendering, and (or) regulation of financial services, and (or) audit of the financial organizations”.

41. The Law on JSCs requires that one third of directors be independent and provides a definition of independence which includes independence from management and controlling shareholders.

42. The Law on JSCs requires chief executives to sit on boards. This requirement has the advantage of strengthening the accountability of chief executives to boards and shareholders and encouraging the flow of information between the board and management, however is potential for conflicts of interest.

43. The Law on JSCs prevents members of the management board from serving on boards of other companies without the consent of the board thus ensuring that senior executives give adequate time to their executive duties and giving the board control over external commitments.


44. The FSA’s fit and proper control is an automated test. The name of proposed directors, along with the term of reference of the position and the CV and qualification of proposed directors are sent to the FSA. Within 20 days the FSA can confirm or decline the approval of a candidate. Face-to-face meetings were abolished following allegations of corruption and bias in the approval regime. It seems that the FSA only interviews directors if their experience appears to be inadequate or if they were directors in banks that have failed. In the particular context of Kazakhstan, an emerging country with weaker public institutions, this is probably the right approach.


Bank practice

45. The boards of all four banks reviewed have less than 10 members which seems to be a size that is fit-for-purpose. In accordance with banking regulation, more than 30 percent of their boards are composed of independent directors. Exhibits 1 and 2 below represent the size and profile of the boards of three of the four banks reviewed.

Exhibit 1: Board size and proportion of independent directors

Board size

7

7

6

0 2 4 6 8

Bank 1

Bank 2

Bank 3

Proportion of independent directors

57.1%

57.1%

33%

0% 20% 40% 60%

Bank 1

Bank 2

Bank 3

Exhibit 2: Board profile

Bank 1

Non-

independent

non-executive -

28.6%

Executive -

14.3%

Independent

non-executive -

57.1%

Bank 2

Independent

non-executive -

57.1%

Non-

independent

non-executive -

28.6%

Executive -

14.3%

Bank 3

Independent

non-executive -

33.3%

Non-

independent

non-executive -

50.0%

Executive -

16.7%

46. Responses to questionnaires and interviews indicate that non-executive on the boards of the four banks under review are mostly chief executives or company leaders, including several bankers and/or financial industry experts. Directors in banks in which, following the crisis, the state became a major shareholder were removed.

47. The banks reviewed have established board committees. Boards and committees also have terms of reference. All banks reviewed have established audit and remuneration committees. Exhibit 3 below illustrates the board structure of three of the banks reviewed. In


two out of the three banks, one committee discharges the functions traditionally attributed to the remuneration and nomination committees. One respondent bank has also established a board risk committee.

Exhibit 3: Board committees

Board committees Audit Risk Remuneration Nomination

Bank 1 YES YES YESCombined with

remuneration

Bank 2 YES NO YES NO

Bank 3 YES NO YES NO

Key weaknesses

Legal framework

48. Responses to questionnaires and interviews indicate that company law and case law have not developed clear, robust standards for director duties. ‘Officer’ duties are provided for in the Law on JSCs, but do not refer specifically to directors. These include the duty to fulfil their obligations faithfully; the duty to ensure proper use of the company’s assets; the duty to ensure the integrity of accounting and financial reporting, including internal audit; and the duty to ensure that information on the company is disclosed in accordance with legislation. However, according to respondents it is very hard for directors to be held liable for being disloyal to the company or for not fulfilling their general duties with diligence and care. As expressed by one respondent:

“There is no clear provision identifying duties of directors. Sometimes the management board acts against shareholders’ interest and it is impossible to sue the board or directors. There are only two articles in the Law on JSCs that provide very broad liability of “officers”. There is no provision that impose on directors a duty of care towards the company”.

49. It seems that boards are more focused on taking the myriads of formal decisions that the law requires them to take instead of exercising due diligence and care in taking fewer, important strategic decisions and monitoring their implementation by management.

50. While the Law on JSCs requires the presence of independent directors on bank boards, their role is not clear. Remarkably, there is no obligation for board committees, including the audit committee, to contain independent directors. This is worrying given the controlling stakes that characterise the ownership structure of the most important Kazakh banks.

51. The current wording of the Law on JSCs is source of uncertainty as regards board committees. The Law states that public companies must have committees but does not


specify which committees or their purpose. Rather the law broadly describes the responsibilities that could be discharged by committees. In practice this creates confusion as to the purpose of board committees as well as the relative importance of each one of them.


52. Fit and proper requirements apply to board members, members of the management board, the chief accountant and “officers of the bank who coordinate and/or control the activities of bank units and have the right of signature”. It is not clear from the wording of the regulation which functions fall under the definition. Responses to questionnaires and interviews indicate that heads of risk management, compliance and internal audit functions, three key control functions within banks, do not fall within the fit and proper remit of the FSA.

53. Responses to questionnaires and interviews indicate that the FSA has no view on the role of independent directors on boards. This goes against supervisory best practice which assigns to independent directors significant control functions over insiders. For example, the Basel Committee recommends the appointment of independent directors to board committees to increase the objectivity of committee decisions. Best practice also recommends that in committees, independent members meet separately, both among themselves and with the relevant control areas, on a regular basis to ensure frank and timely dialogue.

Bank practice

54. Responses to questionnaires and interviews indicate that three out of the four banks reviewed meet very often. One interlocutor confirmed that the board of his bank meets twice a month. In other two respondent banks, boards meet on average more than 12 times per year. As noted above, this seems to be the result of the huge workload placed on the boards which increases the risk of boards rubberstamping rather than carefully considering items on their agenda. However, one respondent bank represents the other extreme as its board only meets four times per year.

Exhibit 4: Number of board meeting per year in three of the banks reviewed

Board meetings per year

Bank 1 > 12

Bank 2 < 6

Bank 3 > 12

55. As regards board committees, the legislative confusion seems to be reflected on banking practice. To begin with, it is not clear from responses to questionnaires and interviews that these committees were established to support the work of their boards. There is inadequate


reporting to boards by committees and the former are not apprised of the work and discussions of their committees. There also seems to be duplication in their roles as issues discussed by committees are discussed to the same extent by the whole board. In short, the committees are viewed as a parallel control structure to boards which makes for a less transparent and probably less effective control environment.

56. The composition of board committees also tends to undermine the effectiveness of the committee structure in the four banks reviewed and explain, at least in part, the seemingly inadequate information flow between boards and their committees. Committees include external members who are not board directors, i.e. persons external to the bank. According to one of our interviewees this helps ensure that the board has the right mixture of skills and experience.

“Our committees include external members because it is considered that there is no additional value if only the same people are part of board and committees. By allowing external qualified members of committee, the right mixture of skill and experience is guaranteed in each committee.”

57. However, from our perspective, the positives are overweighed by the negatives. Board committees include members who are not responsible for the final outcome of committee decisions and are not accountable to shareholders. In addition, the presence of “externals” undermines the confidentiality of committee discussions particularly since it appears that these external do not have even the limited duties that directors have to the company.

58. In addition, it seems that members of the management board can also be committee members. This practice jeopardises the independence of committee recommendations, at least as regards the audit and remuneration committees. Senior executives take part in the decisions of committees responsible for monitoring their actions or the actions of their direct supervisors. While members of management should act as rapporteurs to these committees, they should not be their members.

59. The absence of a senior company secretary in respondent banks further undermines the link between boards and their committees. Responses to questionnaires and interviews indicate that the company secretarial function is mostly administrative and limited in its reach. Board secretaries do not participate in committee meetings and each board committee has its own secretary drawn from members of senior management. For example audit committees are supported by the head of internal audit, remuneration committees supported by the head of human resources and risk committees, when established, by the head of the risk management department. In addition to preventing adequate flow of information, this creates conflicts of interests for members of the management board as the managers that reports to the committees are also their secretaries.

60. As regards director induction, it appears from responses to questionnaires and interviews that the boards of the four banks reviewed have not established programmes of induction and continuous learning and/or training for their members.

61. It seems also that boards do not carry out regular evaluations of their work. At least one respondent bank indicated this not being a practice. However, the bank also indicated that the board was in the process of establishing a regular evaluation process.


Recommendations

Legal framework

62. The legal framework on director duties should be enhanced to include a duty of care and loyalty for directors.

63. The scope of the approval regime should be extended to include key control and client-facing functions.

Bank practice

64. Board committees should not contain outside members who are not members of the board. If outside advice is needed on technical matters, it should be provided to the committee on a consulting basis.

65. The board secretary should be a senior official. He/she should also be responsible for supporting board committees to foster consistency and cohesion between the board and its committees.

66. The boards of the four banks reviewed should have in place a programme of induction and continuous learning and/or training for directors.

67. Boards should carry out regular board evaluations to assess their effectiveness.


3) Risk governance

Key strengths

Legal framework

68. Comprehensive regulatory requirements regarding the organisation of risk management in banks are contained in Decree 359. Annex 1 of the Decree ascribes responsibility to boards for approving the risk policy and monitoring the risk profile of their banks. The Annex also contains a list of risk reports to be reviewed by bank boards. These include the consolidated balance sheet, investment reports and credit risk on a monthly basis, and reports on market risks and capital position on a quarterly basis.

69. Decree 359 requires the establishment of an independent risk management function and requires the establishment of an asset and liability committee as well as a senior credit committee.

70. Decree 359 also requires that banks perform quarterly stress-testing and back-testing and use the results of these tests in their decision-making.


71. Banks are required to present to the FSA a report on their compliance with Decree 359, describing key arrangements and policies as well as banks’ assessment of their compliance with the requirements of the Decree.

72. The FSA meets chief risk officers at least twice a year during supervisory visits.

Bank practice

73. In compliance with regulatory requirements, responses to questionnaires and interviews indicate that the boards of the four banks reviewed get regular and extensive reporting on the risk profile of their banks.

74. Responses to questionnaires and interviews indicate that the four banks reviewed have established a risk function that operates independently. While not required by legislation or banking regulation, it seems that the four banks under review have also appointed chief risk officers. In at least two out of the four banks reviewed, the chief risk officer has direct access to the board. However, one respondent bank admitted that, contrary to best practice, the chief risk officer is not a member of the management board.

75. In compliance with banking regulation, the four banks reviewed have established asset and liabilities committees and senior credit committees. One respondent bank has in addition established an investment committee and a senior risk committee with responsibility for the overall risk profile of the bank, a practice that should be considered best-in-class. In at least two of the four banks reviewed, heads of key business lines, heads of risk functions and heads of the finance and treasury functions usually participate in the meetings of risk management committees.


Key weaknesses

Legal framework

76. Despite being fairly detailed in what is required from boards, senior management and risk management departments, Decree 359 is silent on key areas of risk governance. For example the Decree does not require the adoption of an explicit statement on risk appetite nor the appointment of a chief risk officer.


77. According to Decree 359, the FSA requires boards to review the results of stress test but does not see a role for boards in shaping these stress-tests. Yet, only the participation of the boards in shaping the parameters of firm-wide stress testing can implicate the board in shaping the strategic risk appetite of the bank.

Bank practice

78. Responses to questionnaires indicate that the boards of the four banks reviewed approve the risk appetite of their banks. However, from responses to interviews it seems that what is referred to as risk appetite are ex-post changes mandated in response to positions taken by management. The prevalent concept of risk appetite is not a forward looking, top-down process consolidated in a formal statement that guides risk taking in various areas of bank activity but rather a bottom up approach that the board controls in a rather ad hoc way. As described by one interviewee:

“There is no statement on risk appetite. It is determined by setting limits in the industries. The concentration is reviewed every quarter by assessing and changing the current exposure and by making an industry analysis.”

79. Responses to questionnaires and interviews indicate that only one of the four banks reviewed has established a risk committee at board level responsible for regularly reviewing the risk profile and advising the board on forward looking risk appetite. This is not necessarily a bad thing in principle, given the small size of the boards and, in some cases, the relatively high level of expertise. While boards should be allowed to determine the structure that best suits the needs of their banks, the establishment of a risk committee might ensure that there is adequate focus at board level on risk exposure and future risk strategy.

Recommendations


80. The FSA should require the boards of the four banks reviewed to adopt a forward looking statement on risk appetite. The risk appetite should be communicated to the FSA.

Banking practice

81. Banks with low levels of financial industry expertise should consider establishing board risk committees.


4) Internal control

Key strengths

Legal framework

82. Regulatory requirements regarding internal control in banks are contained in Decree 359. The Decree explicitly confers to bank boards responsibility for ensuring the integrity of financial statements as well as establishing and monitoring the functioning of an effective internal control system. The Decree also ascribes to boards explicit responsibility for reviewing and approving related party transactions and approving policies on monitoring bank operations with connected persons.

83. Decree 359 requires the establishment of an independent compliance function headed by a compliance officer appointed by the board. The Decree also provides that boards are responsible for approving the compliance risk policy and that compliance departments should have access to the resources and information necessary to discharge their duties.

84. Decree 359 provides for the establishment of an independent internal audit function headed by a chief internal auditor appointed and dismissed by the board. The board is responsible for reviewing internal audit reports and following the resolution of identified weaknesses.


85. The FSA gets annual reports on the effectiveness of the internal control system as well as reports on related party transactions.

Bank practice

86. In compliance with regulatory requirements, the boards of the banks reviewed have established independent compliance and internal audit departments.

87. In addition, responses to questionnaires and interviews indicate that the boards of the banks reviewed have organisation charts that are regularly reviewed and that high-level decision-making authorities for the main business and control functions are mapped and documented.

88. Responses to questionnaires and interviews indicate that despite the lack of regulatory guidance, the boards of the banks reviewed have established audit committees that meet best practice requirements. Audit committees are entirely composed of non-executive directors and include a majority of independent directors. They also include at least one member with expertise in accounting matters, an understanding of financial statements, as well as the ability to ask the right questions to determine whether the company's financial statements are complete and accurate. Respondent considered that on balance audit committees possessed the collective balance of skills to perform their duties adequately.


Key weaknesses

Legal framework

89. The crisis and subsequent bailouts in at least two systemically important banks and some smaller institutions showed that related party transactions are a significant challenge in Kazakhstan. Responses to questionnaires and interviews have confirmed this. The effectiveness of the provisions of Decree 359 is undermined by the lack of transparency as regards beneficial ownership. According to interviewees, there are no legal mechanisms to find out beneficial ownership.

90. Banking regulation does not require the establishment of an audit committee. This is a significant omission in an environment of financial institutions controlled by major shareholders with a history of significant related-party transactions.

91. The legal and regulatory framework does not adequately ensure external auditor independence. Responses to questionnaires and interviews indicate that banks are not required to have policies for managing the provision of non-audit services by external auditors nor are they required to rotate external auditors.


92. According to responses to questionnaires and interviews, the FSA does not vet or approve the appointment of the head of internal audit, the chief risk officer and the chief compliance officer.

93. While it appears that the FSA receives a list of affiliated parties and is apprised of related party transactions in banks every month, related party transactions are not effectively controlled by the supervisory authority due to the difficulties in getting information on beneficial ownership.

Bank practice

94. There is a lack of clarity as regards the reporting lines of both the compliance officer and the chief risk officer. It is not clear to what degree they are consider members of the executive management. The reporting line of compliance—and therefore its accountability – is unclear: even though compliance is reporting to the audit committee it still has to report—and is accountable to—the whole board. This might look good, but in reality might simply mean more diffused, weaker accountability. For example we found that despite the fact that key control functions are supposed to report to the board, heads of functions did not seem to know board members.

95. More generally, responses to interview seem to indicate that the implementation of internal control provisions remains a key issue in the Kazakh banking sector. For example, banking regulation requires effective segregation of duties within banks. However, interlocutors have identified segregation of duties as a key internal control weakness. In the same way, related party transactions almost brought about the failure of two systemic banks despite the fact that the law requires board approval of related party transactions. As expressed by one interviewee


“The key issue with regards to related party transaction was the inadequate implementation of relevant regulations by banks.”

96. As regards external audit, the practice of banks varies. At least one respondent bank does not have policies for managing non-audit services and does not rotate external auditors, while it seems that at least one of the four banks reviewed has adopted policies for managing non-audit services and rotating external auditors. However it appears from responses to questionnaires and interviews that external auditor do not generally provide non-audit services. Beyond issues of external audit independence, it seems that the main challenge is the quality of external auditors. According to the Accounting and Auditing ROSC on Kazakhstan, it seems that there is a significant gap between audit reports prepared by local audit firms, generally viewed as poor, and the reports prepared by local member firms of international audit firm networks generally compliant with IFRS.

Recommendations

Legal framework

97. Banking regulation should require the establishment of audit committees in systemically important banks. In addition to supporting the board in ensuring the integrity of financial statements and the effectiveness of the internal control systems, audit committees should ensure the systematic and independent review of significant conflicts of interests between banks, their boards, their directors and affiliates, including related party transactions. The views of the audit committee on proposed related party transactions should also be communicated to the Kazakh FSA.

98. Audit committees should be composed exclusively of non-executive directors independent from management and controlling shareholders. More generally, as discussed above with regards to all board committees, it should be very clear that audit committees are responsible for supporting and advising the board. As such, chairmen of audit committees should be required to report on committee discussions during all board meetings. The agenda and minutes of committees should also be available to boards.


5) Incentives and compensation

Key strengths

Legal framework

99. The board is responsible for determining and approving the remuneration and bonuses of members of the management board under the Law on JSCs.

Bank practice

100. In compliance with the law senior executive compensation is approved by boards which means that management is not in control of the remuneration process.

101. Responses to questionnaire and interviews indicate that less than 20 percent of the total compensation of directors is variable. This is an arrangement that, in principle, should mitigate excessive risk taking.

102. Responses to the questionnaires indicate that at least three of the four banks reviewed have established board remuneration committees responsible for considering and approving the remuneration arrangements of members of the management board and those discharging key functions. In at least one respondent bank, the remuneration committee also exercises oversight over strategic human resources issues.

Key weaknesses


103. At present the Kazakh FSA does not monitor or gather information on executive remuneration. However, responses to interviews indicate that it is considering amending Decree 359 to comply with the recommendations of the G20.

Bank practice

104. Very little is disclosed by the four banks reviewed as regards executive compensation. At least one respondent bank has included in its financial statements the total amount paid to employees.

105. Responses to questionnaires and interviews indicate that shareholders do not approve equity compensation. However, this does not seem to be a significant issue as there are no stock-based incentives for management.

Recommendations


106. The FSA should require more transparency with regards to executive remuneration in line with the recommendations of the G20.


6) Transparency to the market and regulators

Key strengths

Legal framework

107. Some level of transparency to the market is ensured through the requirement that financial institutions and listed companies report in accordance with IFRS. Board members and key executives are required to disclose transactions in their company's securities.

108. The Law on JSCs also require banks to have their annual financial statements externally audited.

Bank practice

109. All four banks reviewed publish audited financial statements on their website. They also publish information on the composition of theirs boards and management boards. Three of the four banks reviewed include short director biographies. In addition, three of the four banks reviewed provide information on board structure and key governance policies.

110. The financial statements of at least two of the four banks reviewed also contain Basel pillar III disclosures, even though it does not appear to be a regulatory requirement.

111. With regards to annual general meeting information, three of the four banks reviewed publish the notices, agendas and voting results on their websites.

Key weaknesses

Legal framework

112. Banks are not required to disclose voting rights attached to different classes of shares and control enhancing mechanisms including caps on voting rights and cross shareholding. Further, it appears from responses to questionnaires and interviews that apart from the financial statements, banks are not required to make additional disclosures on corporate governance, director remuneration or ownership structure.

113. Banks are required to publish audited legal entity financial statements, however, they are not required to publish consolidated financial statements. As a result, depositors and other creditors may face considerable difficulty in getting sufficient information about banks’ complete financial condition.


Recommendations

Legal framework

114. Banking regulation should require systemically important banks to disclose the information necessary to enable the market and other stakeholders to understand their management, governance, financial performance and ownership structure, through annual reports or on the corporate website.

115. In addition, the following information should be communicated to the Kazakh FSA on an annual basis: an operating and financial review; a report on risk along the lines required by Basel pillar III enabling a better assessment of their risk profile and their capital adequacy; and a corporate governance report.

the governance of banks in transition economies kazakhstan ...kazkommertsbank jsc (‘kazkom’):...

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