BASEL COMMITTEE ON BANKING SUPERVISION Corporate Governance in the Banking System Third Pan-African...

BASEL COMMITTEE ON BANKING SUPERVISIONBASEL COMMITTEE ON BANKING SUPERVISION

Corporate Governance in the Banking System

Third Pan-African Consultative Forum on Corporate Governance

Dakar, Senegal

9 November 2005

Kirk Odegard

Secretariat, Basel Committee on Banking Supervision


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Outline

Background

Sound corporate governance principles

The role of supervisors

Unique challenges

Conclusions


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Background


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Background

Organisation for Economic Co-operation and Development (OECD) is international standard-setter for corporate governance

OECD issued corporate governance principles in 1999 Basel Committee issued guidance in 1999 applying

OECD principles to banks Late 1990s/early 2000s: corporate scandals OECD issued revised principles in 2004 Basel Committee currently reviewing bank guidance


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Why guidance for banks?

Critical role in the economy Need to safeguard depositors’ funds Importance of trust and confidence High cost of bank failures Sensitivity to liquidity crises Access to confidential customer information Increasing complexity of bank activities


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Foundations of effective governance

Foundations 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

Banking supervisors should be aware of impediments to sound corporate governance and take steps within their power to promote effective foundations


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Everyone’s responsibility

Board and senior management are primarily responsible for effective corporate governance

Others can help promote sound bank governance:

– Shareholders

– Auditors

– Industry associations

– Governments

– Banking supervisors

– Stock exchanges and securities regulators

– Employees


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Working Group on Corporate Governance

Established by Basel Committee to review guidance

Incorporated elements of 2004 OECD principles

Discussed lessons learned from corporate governance breakdowns

Met with industry groups and rating agencies

Consulted with non-BCBS supervisors

Issued consultative paper in July 2005

Final paper expected late 2005/early 2006


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July 2005 consultative paper

Apply to a wide range of banks and countries

Applicable to diverse corporate and board structures

Principles, not rules

Not as prescriptive as some national legislation

Commensurate with bank size, complexity and risk profile

Not part of Basel II

May be revised based on consultation


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2004 vs. 1999 guidance

Introduction of “know your structure” guidance

Expanded to consider group structures

Protection for “whistleblowers”

State-owned and other non-listed banks

More in-depth discussion of:

– Conflicts of interest

– Role of the board of directors

– Audit and other control functions

– Role of banking supervisors


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Strategic objectives and corporate values

Clear lines of responsibility and accountability

Role of board of directors

Oversight by senior management

Internal and external auditors and other control functions

Compensation policies and practices

Governing in a transparent manner

“Know your structure”


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Establishing strategic objectives and a set of corporate values that are communicated throughout the

banking organisation.


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Strategic objectives and corporate values

Should be established by the board of directors

Corporate culture should foster ethical behaviour

“Tone at the top” is important

Standards should address corruption, self-dealing 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 reprisal


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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


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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


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Setting and enforcing clear lines of responsibility and accountability

throughout the organisation.


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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


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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– Soundness 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


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Ensuring 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.


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The board should…

Understand oversight role and duties to bank and shareholders Avoid conflicts of interest Have sufficient time and energy to fulfill responsibilities Maintain collective expertise 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 in hiring external auditors


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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

– Review of related-party transactions

– Nomination of board members and key executives

– Board and key executive compensation


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Ensuring that there is appropriate oversight by senior management.


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Senior management responsibilities

Should have necessary skills to manage business and exercise appropriate control

Oversee line managers consistent with board 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


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Effectively utilising the work conducted by internal and external auditors, as well as other control functions, in recognition of their

critical contribution to sound corporate governance.


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Auditors and other control functions

Should be:

– Independent

– Competent

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


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Enhancing audit & control effectiveness

Recognise importance and promote throughout bank Enhance independence (e.g., limit non-audit services) Auditors have duties to bank and its stakeholders 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, compliance, legal functions


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Ensuring that compensation policies and practices are consistent with the

bank’s ethical values, objectives, strategy and control environment.


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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


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Conducting corporate governance in a transparent manner.


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Transparent governance

Necessary for shareholders, other stakeholders and market participants to monitor and hold accountable the board and senior management

Need information on corporate structure and objectives Complex cross-shareholdings can impede transparency At a minimum, all banks should make disclosures to supervisors


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What should be disclosed?

Disclosure on public website or in annual report: Board and senior management structure Organisational structure (including ownership) Incentive structure of the bank Code of business conduct and/or ethics Related-party transactions Full annual financial statement with supporting notes and schedules


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Maintaining an understanding of the bank’s operational structure, including operating in jurisdictions, or through structures, that impede transparency

(i.e. “know your structure”).


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Operational structure

Some bank operations may lack or impair transparency

– Particular jurisdictions (e.g. some offshore centres)

– Complex structures (e.g. special purpose vehicles or corporate trusts) Banks may provide services or establish opaque structures for clients Often legitimate and appropriate business purposes


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Supervisory concerns

The use or sale of opaque structures/products may:

– Pose potentially significant financial, legal and reputational risks

– Impede board and senior management oversight

– Hinder effective banking supervision Risks should be appropriately assessed and managed


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Risk management expectations Clear policies and procedures should be in place

– Approval for use and sale

– Identify and manage all material risks Need for such activities should be regularly assessed Corporate governance expectations should be established for all relevant entities Activities should be subject to enhanced audit procedures and internal control reviews Assess compliance with applicable laws, regulations and internal policies and procedures


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The role of supervisors


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Supervisory role

Poor corporate governance practices can be a cause or a symptom of larger problems

Banking supervisors should:

– Promote strong corporate governance

– Determine whether the bank has sound corporate governance policies and practices

– Hold the board of directors and senior management accountable for governance and internal control weaknesses

– Be attentive to warning signs of deterioration in management

– Consider issuing supervisory guidance for governance


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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?


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Unique challenges


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Controlling shareholders

For example, family-owned or other non-listed banks Controlling shareholders can be a valuable resource Unique governance challenge because of influence There should be sufficient checks and balances on

inappropriate activities or influences The board and its directors have responsibility to the

company and all of its shareholders Supervisors should be able to assess fitness & propriety of

bank owners


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State-owned banks

OECD has issued guidance for state-owned enterprises General principles should be applied to state-owned banks Ownership and supervision functions should be fully separated Government should not be involved in day-to-day

management Board independence from political influence should be

respected Objectives of state ownership and state’s ownership policy

should be disclosed


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Two-tier boards

Some countries adopt a two-tier board of directors (e.g. management board and supervisory board)

Basel Committee recognises that both one-tier and two-tier boards may be appropriate

Two-tier boards may be structured differently across jurisdictions, so no specific guidance

Whichever structure is used, principles of sound corporate governance should be in place


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Conclusions


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Wrapping up

Banks have a unique role in the economy, so targeted corporate governance guidance is appropriate

Key elements:

– Board of directors = oversight

– Senior management = internal controls

– Supervisors = promote and assess sound governance Actual practice is just as important as written policies and

procedures


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Questions or Comments?

Kirk Odegard

Member of Secretariat

Basel Committee on Banking Supervision

Bank for International Settlements

[email protected]

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