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CIAO DATE: 2/00
Governance in the Banking Sector
Conference on Crisis & Credit: Restructuring Asia’s Financial Sector Asia Society
October 1, 1999, New York
Good afternoon ladies and gentlemen.
The Asian Development Bank is pleased to co-sponsor this seminar, and deeply appreciate the efforts of the Asia Society in organizing this important event. We also wish to thank other co-sponsors, namely Ankar Capital, the Financial Women’s Association, HSBC, Chase, Paine Webber & the Financial Times.
Good governance is a critical ingredient of sound banking. With hindsight, it is easy to say that bankers, creditors, investors and regulators paid insufficient attention to governance risks in Asia. Clearly this must change. In this session, I’d like to provoke some thinking about what can be done to improve the corporate governance of banks.
The first point is that improved governance will need to focus on both the macro—or systemic—level and on the level of individual banks. Good governance can only take place in a supportive environment. The aim of governments should be to create an environment conducive to good corporate governance practices.
Let’s start with the macro level—what can be done? Six points that are neither exhaustive nor exclusive.
First: Supervisory Independence. Guaranteeing the independence of banking supervisors—one of the core BIS principles—is key. Independence from political influences, from the regulated banks, and from bank customers are all key. Lack of independence exposes the banking system to the risk of regulatory forbearance, ineffective use of public funds for bailouts of poorly governed or managed banks, and politically-driven, poor quality lending. Supervisors must be able to act against errant banks without any delay or subversion, or the need for political approval; their authority must be firmly established, along with legal protection, and shielded from frivolous law suits—and even physical protections—for supervisors who are properly discharging their duties. They also need to be well-paid and empowered. They can no longer be seen as the back office, or “green-eyeshade” people. The appointments of banking regulators should be insulated from political influences.
Second: Financial market structures have not helped good governance. We all know that compared to the banking markets, Asia’s capital markets are underdeveloped. At end-1997, for nine Asian economies, bank loans amounted to nearly 80 percent of GDP, while capital market funding from bond issuance amounted to a mere 10 percent. As a result, the discipline of capital markets on managers is missing; shareholder value is neglected, and—in banking and the corporate sectors—excesses have been allowed to occur. In retrospect, underdeveloped capital markets also played a role in the crisis, as companies without foreign currency revenues went offshore to borrow. Domestic capital, had it been available, would have reduced currency and maturity mismatches.
The concentration of corporate ownership in Asia has also not helped good governance. A study of nine East Asian economies showed that the ten largest families in Indonesia, the Philippines and Thailand control half the corporate sector in terms of market capitalization. More extreme, in Indonesia and the Philippines, ultimate control of about 17 per cent of market capitalization can be traced to a single family. It should therefore not be surprising that related-party lending and evasion of single, or group, borrower limits was the direct outcome of ownership concentration that prevails in many Asian countries. As one owner in fact quipped: “Why own a bank if you can’t lend to yourself?”
Anything that governments can do to change this family-led business model, to stimulate a broader base for corporate ownership—as countries such as Chile have done through the “pension fund socialism”, and its stimulus of capital markets and the professionalization of investment management—could play a major role in strengthening bank governance.
Third: Improving Governance by Promoting Openness. Governments can also support good governance by “importing” it: by allowing foreign banks to operate on the territory, one can import the banking and governance standards associated with sound foreign banks. And, if the market is contestable, this can help force domestic banks to a higher standard. This way, one piggy-backs on the regulatory standards of the foreign country. So good governance may be able to drive out bad—to paraphrase. The same openness may allow better-governed domestic banks to attract more foreign investment. I’d like to think of good governance as a “competitive weapon”. Bank licensing is another instrument that central banks can use to influence the quality of bank governance. An accepted code outlining the duties of bank directors could be a condition for banks to become eligible for deposit insurance.
Fourth. As in some of the developed capital markets, stock exchange listing requirements should require corporate governance best practice for all listed companies and banks. Stock exchanges should require listed companies, including banks, to disclose corporate governance practices, and to justify any deviations from the OECD’s new core principles.
Fifth. Institutional investors should become more activist. At a “systemic” level, minority shareholder rights should be strengthened. As provider of substantial capital, to self-assess themselves, institutional investors should exercise their voting powers to enhance the performance of banks and corporations, and to influence the quality of governance, as CalPERS and TIA-CREFF have done in the US. ADB puts a lot of weight on governance in screening its own investments, and we have recently introduced governance reviews, in our quarterly reporting. But we cannot operate on the scale that the private sector can.
Sixth. The role of rating agencies in influencing corporate governance has also been underestimated. By providing independent analyses of the strengths and weaknesses of banks, rating agencies play a critical role in the capital market. To managements and boards, their comments can be early warning signals which can impel bank strengthening measures. Going forward, rating agencies should focus more on governance risks and develop a methodology that explicitly assesses the quality of governance. The ADB has always emphasized the role of rating agencies in building robust capital markets, and has invested in three rating agencies in India, Thailand and Malaysia.
At the individual bank level, steps can be taken to enhance governance quality. First is selection of directors: only high quality, independent and “value-adding” individuals should be chosen. The OECD’s core principles provide excellent guidance on the role of boards and accountability to shareholders. Key for the banking industry, is the duty of the board to monitor and manage conflicts of interest, including related party transactions. Consideration should be given to making directors personally liable in certain instances of negligent conduct.
Two other critical elements are often absent in the conduct of boards. First, is performance evaluation system to judge the effectiveness of the board as a whole. Second, board members should receive formal training and education on their duties, as well as on the key drivers of bank performance.
Regulators and industry associations should encourage annual “contests” that rate the best and worst boards. The results could go a long way in spurring governance improvements in banks as well as corporations. Such “contests” are conducted in the US by magazines such as Business Week and Fortune, this practice has not yet caught on in Asia.
Also, Asian banks should not hesitate to “import” good corporate governance practices themselves: strategic alliances with reputable foreign banks committed to good governance is one method by which the learning curve can be compressed.
Conclusion
All this—and more—is necessary, but is not sufficient. Just as a “credit culture” is necessary for good banking, a “governance culture” is crucial. These are intangibles that none of the rules can capture. The former Finance Minister of New Zealand, Ruth Richardson, stated that quality governance is derived from the “5Cs”: Formal governance structures will be ineffective unless there is the Conviction of politicians; Coherence of strategy; Capability of officials; Commitment of opinion makers; and the Constant Communication of the value of reform.
Let me end on an optimistic note. We should think of governance as a “competitive weapon”. Asians have begun to recognize this, and they can seize the opportunity created by the crisis to institute effective governance. If they do, corporate governance reforms will continue to be on the top of the reform agenda in the coming years.
Thank you.
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