What we need to understand is banking governance or Corporate governance only makes headlines when things go wrong. The collapse of Barings, a billion-dollar-plus trading losses at Daiwa Bank and Sumitomo Corporation, ended in an embarrassing and costly litigation and regulatory sanctions over derivatives sales practices at Bankers Trust, and other highly publicized cases have raised questions about the adequacy of corporate governance in international financial and other institutions. When you consider the geographic scope and product complexity of today’s financial markets, some have even wondered whether ‘good governance’ is truly achievable in a global banking or any other financial institution.
In examining the root causes of well-publicized losses at Barings, Daiwa, and others, we can take some consolation from the fact that all derived from violations of fundamental, managerial principles of control, such as those dealing with the recording of all trading positions and the adequate separation of duties. As reported in the Report of the UK Board of Banking Supervision on its inquiry into the collapse of Barings, “the failings at Barings were not a consequence of the complexity of the business, but were primarily a failure on the part of a number of individuals to do their jobs properly”.
However, the use of futures and options contracts allowed Mr. Leeson of Barings to take much greater levels of risk, through the leverage involved in these instruments, than might have been the case in other markets.
It took Mr. Iguchi of Daiwa almost ten years to lose $1 billion in unauthorized government bond trading. In less than two months’ time, Mr. Leeson was able to expand Barings’ losses from $374 million to $2.2 billion in his unauthorized trading of Nikkei futures and options and Japanese Government Bond futures. Although the fundamentals of good governance may not have changed that much, global markets and increasingly innovative and complex financial instruments not only make it more difficult to ensure such principles are adhered to throughout a large international organization but also greatly magnify the speed and costs of failure. The punishments for bad governance, as we have seen, can now be amazingly instant as well as severe.
“The financial sector worldwide seems committed to creating ever larger organizations through merger and consolidation and to becoming more dispersed and complex organizations through combining the different products, delivery systems, and cultures of commercial banking, investment banking, securities brokerage, futures and options, life and casualty insurance, mutual fund and asset management services into universal banking or financial conglomerate structures”. The main challenge faced for those who govern these enterprises and for those who regulate and supervise them, is to ensure that the basic tools of good governance board of directors’ oversight and strategic direction, management internal controls, internal and external audit, corporate compliance, and regulatory surveillance and inspection expand and adapt to ensure these enterprises continue to operate within a sound control environment.
Good governance cannot be just defined in isolation. It can only be understood in the context of the various constituencies it is meant to serve and their expectations. Customers, counterparties, and others with whom an enterprise does business generally define good governance in terms of efficiency and quality, a well-governed bank is one that provides efficient, high-quality services and products in a timely manner. Those who work within a bank tend to evaluate good governance on two fronts, job and personal satisfaction. Is management giving me all the tools and support that I need to do my job efficiently and well? Is management treating me fairly and objectively when it comes to such personal matters as salary, bonuses, benefits, and advancement, and does it seek to ensure that I work in a professional environment free from harassment, discrimination, and other forms of personal abuse? Internal constituencies thus tend to be more oriented toward management culture in their assessment of whether they are being well-governed.
Shareholders, which increasingly means institutional investors and securities analysts, evaluate good governance in terms of shareholder value and corporate opportunities. A well-run organization is one that continually seeks to enhance shareholder value, consistently meets earnings projections, and evaluates corporate opportunities in terms of the benefits to shareholders. Thus, a well-governed board of directors will have a substantial number of outside directors to ensure, that proposed takeovers or mergers of the company are fairly considered in terms of the maximization of value to the shareholder in a sale of corporate control. From a shareholder’s perspective, good governance centers on enhancing enterprise value.
Creditors, including banks, depositors, bond holders, analysts, and rating agencies, tend to view good governance in terms of an organization’s ability to meet and service its debt obligations. Good governance means having in place structures designed to provide such constituency with extensive, accurate, reliable, and timely financial information that enables creditors to evaluate regularly the likelihood of repayment of their loans or other credits when due at the negotiated terms. This constituency places its greatest reliance on financial reporting systems and their attendant controls.
The government, defines good governance in terms of compliance with laws and regulations, “from everything to paying the amount of taxes due on time to establishing compliance mechanisms to prevent criminal activity or fraud within the organization”. In a very real sense, government is not necessarily concerned with whether an enterprise succeeds or fails, but whether it meets all of its legal responsibilities as a corporate citizen. Compliance is the critical path to meeting government expectations.
Finally, in the case of the banking industry and certain other financial industries, regulatory and supervisory agencies, whether central banks, ministry departments or divisions, independent agencies or government deposit insurers, have their own concept of what constitutes good governance from a safety and soundness standpoint. Regulatory expectations of good governance tend to encompass all of the expectations of the more-narrow constituencies described above, as regulators are concerned not only with the viability of a particular bank but the impact of that viability as well on the financial system i.e., locally, nationally, and globally. Regulators want governance that effectively manages all material risks confronting a banking organization, whether those risks come from without or within the organization, to ensure that the institution is operating in a safe or sound manner. Safety and soundness considerations require regulators to have the highest expectations that cut across all interests of the organization.
Today, the banking industry is becoming more dominated by institutions with assets approaching half-trillion and even trillion-dollar range. Such size, in and of itself, overwhelms earlier supervisory approaches based extensively on transaction testing by examiners or inspectors. Thus, in the United States, United Kingdom and, increasingly, in pronouncements of the Basle Banking Committee, we can see an acceptance and acknowledgment that a ‘risk-based’ approach to supervision is the most workable, efficient, and prudent in dealing with increasingly larger, more global banking organizations.
Under a risk-based or risk-focused approach to supervision, a supervisor focuses on a banking organization’s principal risks and its internal systems and processes for managing and controlling these risks. Less emphasis is placed on transaction review, except as a means of testing the effectiveness of critical management or control systems. This approach relies upon-and creates high expectations for corporate governance, since, at the end of the day, the supervisor is examining, from the top down, how a banking organization is governing itself. Substantial gaps or failures in that governance thus become the focus of supervisory criticisms and enforcement measures, since regulators rightly perceive that such gaps or failures, especially in huge global organizations, can produce the next Barings, Daiwa, or even worse situation from a systemic standpoint.
“The regulator’s view of corporate governance is functionally oriented and does the organization have in place the necessary systems and processes for managing and controlling the principal risks of its business”? When regulators talk about good governance, they talk about ‘risk management’ in its broadest sense. In this regard, in recent years, a number of sound practice statements issued by the Basle Banking Committee, the International Organization of Securities Commissions (IOSCO), the Group of Thirty, and individual bank supervisors have emphasized the same ‘risk management’ or ‘good governance’ fundamentals for financial institutions:
In 1992, Price Waterhouse was one of four sponsors of a study by Oxford Analytica of corporate governance and the role of the board of directors in the Group of Seven (G-7) countries in the decade ahead. Although a board of directors is still expected to delegate the day-today routine of conducting the bank’s business to its officers and employees, regulators have been more forcefully educating the board that it cannot delegate its responsibility for the consequences of unsound or imprudent policies and practices, whether they involve lending, investing, protecting against internal fraud, or other banking activities. Accordingly, in its proposed Framework, the Basle Banking Committee emphasizes that the board “has the ultimate responsibility for ensuring that an adequate system of internal controls is established and maintained”.
In order to provide effective strategic direction and oversight, a board must be able to exercise independent judgment when managing the bank’s affairs. Boards that merely rubber-stamp management’s recommendations or that are unduly influenced by a single, powerful shareholder or related group of directors are not sufficiently independent to meet their responsibilities. There has thus been a trend toward requiring the election or appointment of more outside directors on the board, who are not part of management and have no family or related ownership interest in the institution. In particular, it is viewed as increasingly important that a bank’s Audit Committee be composed entirely of outside directors.
In the United States, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) requires that all audit committee members of large banks with assets greater than $500 million be outside directors who are ‘independent of management’. The United Kingdom’s Cadbury Committee also recommended that audit committees be comprised of non-executive directors, with the majority independent of the company. The Basle Banking Committee’s recent Framework also implicitly endorses the benefits of having an independent audit committee “overseeing the financial reporting process and the internal control system”.
Bank supervisors will thus seek to determine whether, in fact, a bank’s board is independent and is meeting its responsibilities set forth above for setting the bank’s strategic direction and for ensuring that the bank has established an adequate system of internal controls for managing its risks. As part of this evaluation of the board’s role, a bank supervisor will review the adequacy of Management Information Systems (MIS), that provide the board and its audit or other committees with the information they need to perform their oversight role. In this regard, the bank’s risk control function should periodically provide the board with ‘useable’ information illustrating exposure trends, the adequacy of compliance with policies and procedures and risk limits and risk-return performance.
We can conclude good governance by a bank’s board requires independence, high ethical standards, knowledge of the bank’s business and the markets in which it operates, strategic direction, and effective oversight of the establishment and implementation by management of a sound internal system of controls, policies, procedures, and limits for managing all material risks. While it is of critical importance to define the elements of ‘good governance’ at commercial banks, it is equally, and perhaps more, important to identify those elements of ‘bad governance’ that are likely to lead to significant losses or even failure. When these governance ‘red flags” pop up during internal or external audits or bank inspections or examinations, bank supervisors need to respond promptly to ensure they do not evidence deeper governance or control problems within the banking institution.
The elements of good governance cannot be found in secret formulas, complex structures, or magic bullets. They are based on long-standing and well-tested principles of enterprise direction, management, and control. As the world’s banking institutions get ever larger and more diverse, the details of corporate governance become ever more important to institutional and systemic soundness.