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
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