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Dealing With Bank Corporate Governance Risks

Louis Kasekende (PhD), the deputy governor of the Bank of Uganda, was a key note speaker at the MUBS’ 5th Annual International Leadership Conference on June 26, at which he presented a lecture titled ‘Corporate Governance and the Performance of the Financial Sector.’ This is an edited version of the lecture.

The function of corporate governance is to ensure that business enterprises are managed in a way which is not destructive to the wider society or to particular groups of their stakeholders. What is special about the financial sector, which makes corporate governance so important?

Several intrinsic characteristics of the financial sector make it particularly vulnerable to conflicts of interest whereby the “insiders”, who are those with the power to control the management of financial institutions, can exploit their power to profit at the expense of other stakeholders – the so called “outsiders” – who include depositors, non-controlling shareholders and the general public. These intrinsic features of the financial sector are the following.

First, financial assets involve claims on the future. If you hold a share in a company or a deposit in a bank, you have a financial claim which can be realised at some point in the future. The future, however, is inherently uncertain, hence the value of any future claim is also uncertain it is contingent on events which have yet to happen. This might not be a problem if the same information needed to make informed judgments about the likely future value of financial assets was available to everyone.

But this is rarely the case information is not perfect. Instead there are informational asymmetries. Insiders are often much better-informed about the future prospects for financial assets, which they control than are outsiders, in large part because the future value of such assets is subject to actions taken by the insiders themselves. As a result, the balance sheets of banks are inherently opaque, especially because a large share of their assets comprises loans whose true value is not directly observable by outsiders. Hence it is very difficult for outsiders to evaluate accurately the true value of a bank’s assets and thus its true financial condition.

Second, commercial banks and some other types of financial institutions (such as hedge funds) are among the most highly geared of all business enterprises. Bank capital as a share of their total liabilities is almost always less than one fifth and usually less than 10% (in Uganda, aggregate bank capital is 17% of total liabilities).

When this very high gearing is combined with the limited liability of shareholders, a feature of commercial law, which is common in all modern societies, bank shareholders face an asymmetric alignment of incentives pertaining to the potential gains and losses of risk-taking by the bank which they own. In essence, all of the profits of successful risk-taking accrue to the shareholders, whereas, with the exception of the very thin layer of capital, the losses of unsuccessful risk-taking are borne by the bank’s creditors, who are mainly depositors.

Third, most of the liabilities of banks are owned by a very large number of atomised depositors. These depositors have most to lose from reckless or abusive bank management but because of both a lack of knowledge and “free rider” problems, depositors are not in a g position to exert any restraining influence over bank management.

Fourth, the potential damage, which the failures of large financial institutions – so called systemically important financial institutions – can inflict on the economy, is enormous. Economic recessions caused by financial crises are much deeper and last for longer than is typical for recessions. The prolonged recession in many aanced economies of the world following the global financial crisis is an example of this.

Finally, in most market economies including Uganda, the government provides some form of explicit bank deposit insurance. Governments are also widely assumed to provide an implicit guarantee to bail out systemically important financial institutions, which are deemed to be too big to fail, because their failure would have disastrous consequences for the economy.

These guarantees for bank creditors – explicit and implicit – intensify moral hazard in the financial system, in that they switch the burden of bearing the costs of bank failure from bank creditors to taxpayers, thereby weakening further any restraining influences on reckless or abusive bank management, which might be exerted by creditors.

The consequences of these intrinsic features of the financial system are twofold. The first is that management of financial institutions, and especially banks – because they are most highly geared and are covered by deposit insurance – have incentives to engage in much riskier business strategies than is socially optimal. Hence bank failures are more likely to occur, at the cost of their depositors and the taxpayers.

The second consequence is that insiders may have incentives to actually loot their own institutions, through, for example, insider lending, at the expense of non-controlling shareholders as well as depositors and the taxpayers.

In essence, corporate governance in financial institutions is intended to ensure that the legitimate interests of all three groups of outsiders – non- controlling shareholders, depositors and the general public – are properly taken into account in the management of these institutions.

What is the relationship between corporate governance and regulation in the financial sector? The objectives of bank regulation and supervision – to protect depositors and the systemic stability of the financial sector – are very similar to those of corporate governance in the financial sector that I have just discussed.

You might thus wonder why we need to bother with corporate governance when we have public regulators, such as the BoU, whose responsibility it is to prevent the reckless and abusive management of banks in order to safeguard the interests of deposits and the general public. Might this not be a case of the regulator trying to evade its own responsibility? My answer to this question is that no financial regulator is omnipotent.

Furthermore, the ability of the financial regulator to monitor and influence the behaviour of the management of financial institutions depends heavily on the business environment in which these institutions operate and thus the incentives which their managers face.

This was illustrated very clearly by the global financial crisis, the causes of which included major failures of corporate governance. One of the lessons I would draw from the global financial crisis is that financial regulation by a public regulator will only be effective if good corporate governance is at least the norm within the financial sector, if not in all financial institutions. I will return to this issue shortly.

Bank failures in Uganda:

Uganda’s approach to the reform of corporate governance in the financial sector has been shaped by the lessons we drew from several bank failures more than a decade ago and by the evolution of international standards in this area.

In the 1990s and early 2000s, Uganda’s banking industry suffered a number of bank failures. Eight banks failed, forcing BoU to intervene and resolve them. In some cases the failed banks were closed, in others they were sold to new owners. The primary cause of most of these bank failures was poor corporate governance. In many of the failed banks, a dominant shareholder or group of shareholders was able to exert undue influence over the management of the bank, which resulted in abuses such as pervasive insider lending. The losses incurred on insider loans were the single most important contributor to the collapse of these banks.

The bank failures of the 1990s prompted the BoU and the Government to strengthen banking regulation. Parliament enacted new legislation in 2004 – the Financial Institutions Act (FIA) – which, inter alia, raised minimum bank capital requirements, tightened restrictions on insider lending and mandated the BoU to intervene promptly in failing banks before their capital is completely eroded and their depositors suffer losses.

However, BoU and the Government also recognised that statutory bank regulation and supervision by a public agency cannot be expected, on its own, to guarantee the sound management of banks, as I have already noted. Moreover, excessively heavy handed regulation, although it might protect depositors, can also stifle innovation and risk taking in banks, which would be detrimental to economic development. In a market economy, the onus for sound management, including the proper management of risks, must lie with the banks themselves. [Good] bank regulators cannot be a substitute for bad bank managers. As such, good corporate governance is an essential complement to good bank regulation and supervision.

Uganda’s corporate governance regulations were influenced by the guidance published by the Basel Committee on Banking Supervision, based at the Bank for International Settlements, which is responsible for formulating global standards for bank regulation and governance. The corporate governance regulations in Uganda focus on four key themes, which I will briefly elaborate on.

The Board of Directors (BOD):

Uganda’s corporate governance regulations place great emphasis on the fiduciary responsibilities which the BO D owes to the bank, its depositors and shareholders and to the wider society. The BOD collectively must take ultimate responsibility for the performance of the bank and for the manner in which it conducts its operations. The directors must lead from the top.

They must set the strategic policies of the bank and establish its corporate values. They must also ensure that the bank’s policies prohibit corruption and conflicts of interest in the bank’s operations. An important function of the Board is to define clearly the duties and responsibilities of each member of the bank’s senior management.

To exercise their responsibilities, the directors themselves must be of the highest integrity and have the professional expertise necessary to understand the nature of a banking operation and, in particular, how it differs from that of a non-bank company, and what that means for the fiduciary responsibilities of the directors. Uganda’s corporate governance regulations also stress that an individual director cannot hide behind collective board responsibility. Each director can be held individually responsible for any failings of the bank. He or she has a responsibility to report in writing to the bank regulator – the BoU – if he or she has any reason to doubt that the bank may not be able to meet all of its obligations to its creditors or may not be able to operate as a going concern in the future.

Independent oversight of bank management:

Uganda’s corporate governance regulations stipulate a clear demarcation of responsibilities between the bank’s BOD and its management. This is a very important principle. The Board must be able to exercise oversight of bank management and hold it to account, which will only be possible if most of the directors are independent of the bank management.

This principle is sometimes violated in this country, where the distinction between the respective responsibilities of directors and management is sometimes poorly understood. To ensure that the Board can be independent, Uganda’s corporate governance regulations stipulate that at least half of the directors of a bank, including the Chairperson of the Board, must be non-executive directors. The non-executive directors should not participate in any way in the day to day running of the bank. In essence, the Board represents the interests of the bank’s outsiders its non-controlling shareholders, its depositors and the general public. The Board can only properly represent the interest of the outsiders if they are truly independent of the management of the bank.

Risk management:

Bank operations are inherently risky. Banks incur credit risk, liquidity risk, market risk and operational risk. Some degree of risk taking by banks is socially desirable otherwise there would be virtually no lending to firms and households. However, the amount of risk, which a bank incurs, must be commensurate with its ability to absorb losses and its managerial capacities for understanding and controlling risk.

Because bank insiders have aerse incentives to engage in excessive risk taking, the Board, which represents the interests of bank outsiders, must take the lead in formulating effective risk-management policies and procedures and in monitoring their implementation by the bank’s management.

The corporate governance regulations require Boards to establish two Board sub-committees for purposes of risk management a Risk Management Committee and an Asset Liability Management Committee.

Audit function:

Uganda’s banking regulations emphasise the importance of the role played by independent internal and external auditors in ensuring good corporate governance and, in particular, ensuring that the bank’s financial statements accurately and fairly reflect its true financial position. Each bank must have an internal auditor who is independent of the bank management and who reports to the audit committee of the Board.

Conclusion:

Banks perform a unique role in a modern market-oriented economy. When banks work well, they contribute to economic growth by allocating scarce financial resources efficiently and allowing private companies and individuals to undertake productive investments, which they could not fund fully from their own resources. When banks work badly, which is not uncommon, they can inflict damage throughout the economy, causing losses to depositors, firms who need credit and taxpayers.

Source : The Independent

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