Corporate Governance and Financial Stability The Governance of by cnu54265


									                              Teresa Barger
                Corporate Governance and Capital Markets
                            IFC & World Bank

Corporate Governance and Financial Stability:
         The Governance of Banks
  FICCI-IBA Conference on Global Banking
              September 2006                      1
               Outline of Presentation

     Defining Corporate Governance
     IFC / World Bank and Corporate Governance
     Corporate Governance and Financial Stability
     Bank Governance
     IFC’s Bank Governance Toolkit
     Case study: Banco Comerciala Romana (BCR)

              Defining Corporate Governance
             OECD Principles of                    Distinguish from:
            Corporate Governance
           provide the framework:
                                              Corporate Citizenship
       Shareholders and Other Financial      Corporate Social
        Stakeholders                           Responsibility
       The Board of Directors and            Socially Responsible
        Checks and Balances                    Investing
       The Control Environment: Audit,
        Transparency and Disclosure           Political Governance
       Commitment to (and
        Enforcement of) Good Corporate
                                               (But CG does reinforce
        A Practical Investment-Driven              all of these)

The Corporate Governance Value Proposition

    Provides Access to and Lowers Cost of Capital

                                                    Value Added
    Improves Operational Efficiency; Manages Risk

        Improves the Company’s Reputation

            Support for The Value Proposition

       S&P, Moody’s and Fitch - CG Explicit Part of Credit Rating
       Activist Institutional Investors - CalPERS Governance
        Portfolio Performance
       Deutsche Bank research: S&P500 firms with good governance
        outperformed those with poor governance by 19% over two
        year period
       McKinsey Survey: institutional investors would pay:
        – 22% premium for well-governed companies in Asia and Latin America
        – 30% premium in Eastern Europe and Latin America
       CLSA research: best governed companies in India and East
        Asia had Economic Value Added (EVA) 8% higher than
        national averages


    “The Modern Corporation and    Reality of Emerging Markets
      Private Property” (1932) –    Concentrated Ownership
      Berle & Means                 Concentrated Business
     Separation of Ownership        Elites
      and Control                   Management Selected by /
     Principal / Agent Problem      are Controlling
     Managers vs. Dispersed         Shareholders
      Shareholders                  Family Identification

                                   (Similar to Continental
    (Most apposite in US/UK)          European Patterns)

IFC / World Bank Corporate Governance Activities





       Assessment of Policy Framework in ROSCs
        (Reports on the Observance of Standards and
        – Official assessor of the OECD Principles of CG
     Assessment of Corporate Governance of SOEs
     Reviews of Bank Governance Regulatory


       Global Corporate Governance Forum
        – Provides tools for reform
       IFC PEPs (Private Enterprise Partnerships)
        – Provide on-the-ground Technical Assistance (TA)
       Policy Roundtables


    IFC Corporate Governance Methodology
     – IFC as only investor with tested methodology to
       assess and improve governance of companies
    IFC Nominee Directors on Boards
     – Where IFC is a significant equity investor

             Financial Stability Forum

  Post-Asian Crisis
  G7 established
  Focus on global stability
  12 Reports on Observance of Standards and
   Codes (ROSCs)
     – 9 by IMF
     – 3 by World Bank, including Corporate

 Corporate Governance and Global Stability

    Listed-market focus
    Investor protection via:
     –   Regulation and enforcement
     –   Shareholder rights
     –   Legal redress
     –   Disclosure standards and infrastructure
     –   Board as fiduciary, with information, judgment
    Protection against “big surprises” a la MCI,
     Parmalat, Hyundai
    Related to Accounting and Auditing (also a ROSC)

                Common Findings

  Enforcement of regulations lacking: will,
   resources, clout
  Market for control often constrained
  Related party transactions not effectively
   controlled by Board
  Companies not serious about finding best
   Board for business
  Very few court cases re: director liability,
   shareholder redress

               Sample Diagnoses - Responses
   Concentrated Ownership Issues        Clearly Articulated Shareholder
  Minority Shareholder Mistreatment      Treatment Policies
 _____________________________         ____________________________
  Ineffective Boards                   Strengthen Boards
      – Poor Capacity
      – Passive Approach
 _____________________________         ____________________________
  Founder/Family Business Issue        Succession Planning, Constitution
 _____________________________         ____________________________
  Conflicts of Interest                Committees and other mechanisms to
                                          handle conflicts
 _____________________________         __________________________________
                                        Audit Committees
    Transparency                           – Internal Audit
      – Internal Controls                   – Financial Professionals
      – Audit Function                    Accounting and Auditing

Financial Stability and Bank Governance

  Governance scandals in publicly listed banks
   undermine public confidence in the public
   equity markets and banking sector
  Poorly governed banks and financial
   institutions threaten the stability of the
   banking system or whole financial system

Bank Governance – What makes banks special?

 1.   Banks as Public Interest Entities
 2.   Extra risks and complexities
 3.   Governance responses
 4.   Academic Evidence

     Bank Governance – Public Interest Entities

     Banks as Public Interest Entities
     Depositors and public shareholders exposed
     Government as lender of last resort, moral
     Macroeconomic importance (savings allocation)
     Systemic risk - failure of one bank can trigger
      banking system crisis (contrast with industrial
     Government intervention
       – For good reasons and bad

     Bank Governance – Extra risks and complexities

 “A badly governed bank is simply a bad bank”

     Dominance of risk management issues
     Delegation of authority / power to bind goes deeper
      into bank’s management
      – Management structure and responsibilities is a governance
     Related party transactions
     Importance of internal information flows
     Highly regulated
     Bank Governance – Extra risks and complexities

 “The purpose of a bank is to manage risk,
 not avoid risk”

     Opacity of assets (loan quality)
     Uncertain liabilities
     Ability to quickly change risk profile
     Ability to hide problems
     Additional risk management issues, e.g. Anti-Money

 Bank Governance – Governance responses

    Banking is already a highly-regulated sector
     – New regulations address governance specifically
     – Banks need to go beyond minimum compliance (especially
       in risk management)
     – What should be regulated?
    Typical regulations:
     – Deeper and more frequent disclosures (compared to listed
       industrial companies)
     – Eligibility criteria for significant shareholders
     – Limitations on ownership concentration
     – “Fit and proper” test for directors and officers
     – Additional Board committees
Bank Governance – Governance Responses

    Role of a Bank Board
     – Greater emphasis on oversight role than on strategic role
     – Defining role of board versus management
     – Committee structure (Board committees versus management
     – More frequent board meetings
    Accountability / check and balances within the bank’s management:
     – Credit
     – Compliance
     – Portfolio / asset quality reviews
     – Risk identification and management (operational, asset/liability,
     – Ensuring quality of internal information flows
    Human Resources limitations may drive structure and procedures
     – Basel II needs directors and senior management who understand risk
     – But cannot expect every director to be a risk management expert
     Bank Governance – Academic Evidence?

      Small but rapidly growing body of academic
       literature and evidence
      Luc Laeven and Ross Levine, “Corporate
       Governance, Regulation and Bank Risk Taking”
      1.   Large owners with substantial cash-flow rights induce
           banks to increase risk
      2.   Two key components of Basel II (capital requirements
           and official supervisory oversight of banks) do not affect
           bank risk taking
      3.   Regulations that promote loan diversification and allow
           diversification of cash-flows by engaging in non-lending
           activities reduce bank risk

       Bank Disclosure Index - Explanation

    Huang, Rocco, Bank Disclosure Index: Global Assessment of
     Bank Disclosure Practices (World Bank, September 2006)
    Compares disclosure practices of individual banks in 177
     countries across six categories
     1. LOANS: breakdown of loans by maturity, type, counterparty, credit
        risk, problem loans
     2. OTHER EARNING ASSETS: breakdown of securities by type, and
        hold purpose
     3. DEPOSITS: breakdown of deposits by maturity, type of customer
     4. OTHER FUNDING: breakdown of money market funding, and long-
        term funding
     5. MEMO LINES: disclosures of capital ratio, reserves, contingent
        liabilities, off-balance sheet, etc
     6. INCOMES: breakdown of non-interest income and disclosure of loan
        loss provisions

     Bank Disclosure Index – India scores well, but …

        Ranking out of 177 and composite indices out of 100:
     1st = Hong Kong (composite index 91)
     25th = USA (76)
     32nd = India (74)
     37th = Sri Lanka (73)
     41st = Nepal (73)
     45th = Singapore (71)
     47th = UK (71)
     87th = Pakistan (59)
     93rd = Bangladesh (57)

        Disclaimers:
     –     Just one (important) aspect of bank governance
     –     Rewards disclosure, but not accuracy, of numbers

      … big red flag on Loan Disclosure

 Composite Index                74
 1. Loans                  19
 2. Other earning assets   99
 3. Deposits               99
 4. Other funding          99
 5. Memo lines             84
 6. Income                 98

                Global bank governance
                 initiatives are booming
    National banking regulators
     – Bank governance codes or regulations
     – Mandate versus guidance
     – Coordinate with other codes and regulations
    Basel Committee on Banking Supervision
     – “Enhancing corporate governance for banking organizations”
       (revised 2005)
    Basel II
     – Not explicitly governance focused, but will impact governance
     – Risk-based supervision relies on Board
    World Bank
     – Studies of bank governance regulations and framework (new product)
    OECD
     – Asia Roundtable Bank Governance Task Force

             World Bank Reviews of
         Banking Corporate Governance
 Common Findings
  Bank supervisors weak clout compared to bank
  Related party transactions : Achilles heel
     – Many Boards hide behind the law
    Boards members know the market but clueless on
     risk management
    Government interference and unintended
     consequences: too much risk or too little
    Conflict between duty to depositors and to (large)
          Indian Banks Are Constrained

    India ranks 7th out of 9 Asian Countries in
     financial depth
     – Financial assets 160% of GDP versus Japan at
    Majority (57%) of lending goes to least
     productive sectors

                    Indian Banks Constrained
 Source: McKinsey         % of commercial   Real value added per
                          credit            worker

 Corporate lending -      30%
 discretionary                              $10,400
 Corporate lending -      13%               (private companies)
 SOEs                     39%               $5,600

 Agriculture              11%               $1,100

 Household enterprises    7%                $500

       IFC’s Experience at the Bank Level

  Extensive investment portfolio in banking
   sector, both equity and debt
  IFC nominee directors on bank boards
  Applying IFC CG Methodology
     – Tailored to bank and FIs
     – Extra questions and extra model documents
    Bank Governance Toolkit

          Why Does IFC Care About CG?

    Portfolio Performance
     – Poor Governance Increases Risk
     – Improving Governance is a Value Proposition
  Development Mission (Sustainable
   Development – Along with Social and
   Environmental Sustainability)
  Reputational Risk / Reputational Agent

     IFC Corporate Governance Methodology

    Emphasis on Value-Added, not Scoring
    Tailored for different types of companies
      –   Listed Companies
      –   Unlisted, Family Companies
      –   Banks and Financial Institutions
      –   SOEs
    CG Progression Matrices
      – Emphasize progress, not minimum standards, from
        “acceptable” to “better” to “desirable” to “best practice”
    CG Information Request Lists
    Sample CG Improvement Programs
    Independent Director Definition

              Core Tool – Simple Progression Matrices

                                   1. Acceptable   2. Better    3. Desirable   4. Best
              Commitment to
              Good Corporate
              Structure and
              Functioning of the

              Board of Directors
              Treatment of
              Shareholders                     PROGRESSION
              Internal Controls

              Transparency and

     IFC Corporate Governance Methodology

                              Evaluate,         Structure Deal;   Supervision;
                               Articulate,       Terms and         Monitoring;
           Identify Issues;     Prioritize CG    Conditions;       Support;
           Engage Client       Risks and         Pricing and       Feedback;
                              Opportunities     Disbursement      Lessons

                   Bank Governance Tool Kit

    IFC’s new Bank Governance Tool Kit builds upon existing focus
     on governance of financial institutions
    Use for both Assessment and Value-Added guidance for:
     – The Board of Directors and Board Committees
     – Senior Management roles
    Not intended as a rigid, one-size fits all approach
     – Every area is divided into “acceptable”, “better”, “desirable” and “best
     – Smaller banks need not have all the committees or all the senior
       management positions (but do need to divide the same functions among
       existing committees and positions)
    Publicly available on IFC website:

     Bank Governance Tool Kit - Charters

  Board Charter
  Audit and Compliance Committee Charter
  Compensation Committee Charter
  Corporate Governance / Nomination
   Committee Charter
  Risk Policy Committee Charter

Example: Contents of the Risk Policy Committee Charter

    Establishment
    Purpose
    Composition
    Individual Committee Membership Qualifications
    Committee Chair
    Appointment
    Remuneration (in addition to compensation for work as a member of
     the full Board)
    Meetings
    Attendance and Notice
    Reporting to the Board and Shareholders
    Evaluation
    Authority and Resources
    Responsibilities – Policies and Procedures
    Responsibilities – Specific Risk Reviews
       Bank Governance Tool Kit - ToRs

  Terms of Reference for the Chief Executive
  Terms of Reference for the Chief of Internal
  Terms of Reference for the Chief Risk Officer
  Terms of Reference for the Chief Compliance

Example: Terms of Reference for the Chief of Internal Audit

    Personal Qualification
    General Knowledge and Professional Skills
    Appointment
    Reporting Line and Accountability
    Reporting
    Resources
    Responsibility – Internal Audit & Control Environment
    Responsibility – Accounting Policies and Procedures

     Bank Governance Tool Kit: Board Self-Evaluation

      Self-evaluation by the Board should be
       standard practice (but it isn’t!)
      Two types:
 1.    Evaluation of the Board’s effectiveness by
       each Board member
 2.    Evaluation of each director by every other

     Corporate Governance as an Investment Thesis:
           Banco Comerciala Romana (BCR)

    BCR in 2003
    Largest Commercial Bank in Romania
    US$1 billion book value
    State-owned (70%), with minority (30%) held by
     Investment Funds (SIFs)
    Two failed privatization attempts in 2002
    Management and board indistinguishable
      – Board composed of senior managers and SIF
      – met more than 25 times annually
    Risk management and internal controls systems weak
               BCR: IFC’s Investment

    12.5% + one share for US$111 million
     – .88x book value
     – Negotiated pari passu and in tandem with EBRD
     – Tag-along / drag-along
  Medium-term trade sale anticipated (no IPO)
  Subsequent distribution of 8% to
   management, employees and retirees
  Institution-building program

 BCR: Corporate Governance Program Put in Place

    Philosophy – “Governance for the Interim”
    Introduced Two-Tiered Board Structure
     –   Management off the Supervisory Board
     –   Redrafted Charter
     –   Amendments to Banking Law
     –   Audit & Compliance and Compensation Committees
    IFC and EBRD-nominated directors
    Active engagement at Shareholders Meeting
    Two-Stage Training Program
     – IMD/IIF Seminar
     – In-house Program

            BCR: Initial Results Were Good

  Rating Agency Upgrades
  Board effectiveness (committees still nascent)
  Professionalization of Shareholders Meetings
  Implementation of control systems
     – Improvement of Risk Management and Internal Controls
     – IFC-sponsored Resident Advisor to Internal Controls Unit

    Transparency sufficient to privatize
              Full Privatization with
           Spectacular Financial Results
  11 interested bidders initially
  2 finalists: Erste Bank (Austria) and BCP
   (Portugal) bid for Gov’t and IFC/EBRD
  Erste wins bidding: €3.75 billion for 61.88%
     – ~6x book value of €1 billion at June 2005
     – IFC’s 12.5% stake worth €758 million

     Corporate governance pays.

             112% IRR

                  Thank You

            Questions or comments?


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