Jaime Caruana: Basel II and corporate governance issues
Speech by Mr Jaime Caruana, Governor of the Bank of Spain and Chairman of the Basel Committee
on Banking Supervision, at the 2nd Islamic Financial Services Board (IFSB) Summit 2005: The Rise
and Effectiveness of Corporate Governance in the Islamic Financial Services Industry, Doha,
24 May 2005.
* * *
Introduction and overview
I would like to thank His Excellency Governor Abdulla Khalid Al-Attiya and the Qatar Central Bank the
hospitality and Professor Rifaat and the Islamic Financial Services Board for inviting me to speak this
evening before such a distinguished gathering. It is a great honour for me to be here at what I am sure
will be a most successful and rewarding Summit. I consider it a privilege to have the opportunity to
share with you some thoughts on two timely and important topics: corporate governance and the Basel
II capital framework.
My contribution to this important conference comes with a degree of humility. Although I understand
that some of the roots of Islamic finance can be traced back to my own country during the time it was
known as al-Andalus, I cannot claim to be an expert in Islamic finance, and I certainly would not
presume to talk about the specificities of Islamic banking before such a knowledgeable audience.
Suffice it to say that we all know that there are differences between Islamic banking and what we
normally refer to as "conventional" banking. However, I do think that we share some important broader
perspectives, particularly in relation to the two issues I will address today. More rigorous risk
management anchored in strong corporate governance, enhanced transparency and sound minimum
capital requirements that reflect the risks that banks face are vital elements for any financial system to
promote confidence and foster financial stability. On top of that, common standards in these areas can
help to improve the integration of the international financial system.
It is certainly true that the special features of Islamic banking may not be fully addressed by the
traditionally broad international standards developed by organisations such as the one I chair - the
Basel Committee on Banking Supervision. I believe that it would be neither appropriate nor possible
for the Basel Committee to seek to fill such gaps. That is why I am very pleased to see organisations
such as the IFSB addressing issues related to the soundness and stability of the rapidly growing
market for Islamic financial services worldwide. The exposure drafts that you have issued with regard
to risk management and capital adequacy for institutions offering Islamic financial services help to fill a
very important niche, as will your forthcoming exposure draft on corporate governance, and your work
on the supervisory review process and on transparency and market discipline.
The Basel Committee is an outward-looking committee, with a key interest in relevant matters that
reach beyond its own technical and geographical borders. I am personally committed to enhancing our
co-operation with non-member countries and with organisations that have related interests. In this
respect, I am confident that the fruitful dialogue that has already begun between the Basel Committee
and the IFSB will continue to be successful and mutually rewarding in the future.
My talk this evening will address several issues. First, I will talk about why I believe sound corporate
governance plays such an important role in bank safety and soundness and financial system stability.
Second, I will share some thoughts on how the Basel II capital framework will contribute to better
corporate governance. Finally, I will share some of the work that the Basel Committee has underway
with regard to bank corporate governance.
Why does corporate governance matter for banks and bank supervisors?
Before I talk specifically about the corporate governance of banks, I would like to discuss more
generally some of the weaknesses in corporate governance that have led to high-profile failures such
as Enron and Parmalat over the past few years. While every situation is unique, and in some cases
not all of the facts are known, many of the recent corporate governance breakdowns appear to have
several factors in common:
- The board of directors failed to understand the risks that the firm was taking, and did not
exercise appropriate oversight or questioning of senior managers' and employees' actions;
- Conflicts of interest and a lack of independent board members and senior executives
resulted in decisions that benefited a few at the expense of the many;
- Internal controls were either weak or non-existent, or appeared to be adequate on paper but
were not implemented in practice;
- Internal and external audit "fell asleep at the switch" and failed to detect fraudulent
behaviour, and in some cases even aided and abetted such behaviour;
- Transactions and organisational structures were designed to reduce transparency and
prevent market participants and regulators from gaining a genuine picture of the firm's
condition;
- And perhaps most importantly, the corporate culture fostered unethical behaviour and
discouraged questions from being raised.
Fortunately, none of the high-profile corporate scandals of recent years have brought down banks. I
would like to think that strong, effective banking supervision has been very helpful in that regard and I
also believe that a sound risk management culture has become increasingly present in the banking
sector in recent decades. This does not mean that we can rest; banks are not immune from any of the
factors that I have just described. Indeed, if we were to look closely at bank failures large and small
over the years, I believe we would find that poor corporate governance lay at the heart of many of
these failures.
Why should we have higher expectations for the governance of banks than we have for other firms?
Fundamentally, because banks must act in a way that promotes "confidence" to the public and the
markets in general and, more specifically, to their primary stakeholders. Banks play a crucial role in
the flow of capital within an economy and are charged with a special public trust to safeguard
customers' wealth. A stable and healthy banking system is critical to the long-term growth of an
economy.
Banking supervisors have long recognised the importance of good governance; supervision can not
function properly if sound corporate governance is not in place. Experience underscores the need to
have appropriate levels of accountability as well as sufficient checks and balances. For banking
supervisors, although the range of topics that corporate governance may encompass is quite wide, the
focus is mainly on those elements that relate to the manner in which the business and affairs of an
organization are governed by its board and managers. This means the decision-making process within
the bank, the respective responsibilities and accountabilities of the board and managers, the control
functions that provide assurance to the monitoring processes and the structures that support all these
functions.
Good corporate governance and supervisory actions complement one another. The guidance,
inspections and oversight activities of supervisors cannot guarantee, on their own, the prudent
operation and financial soundness of a supervised bank. Banking supervisors must rely on the
competence, skills and prudence of the board and management. Confidence in the corporate
governance processes at the bank will enhance the supervisor's overall confidence that the bank is
being operated prudently. This may be reflected in the intensity of supervision applied. In addition,
supervisors may expect a bank's governance structure to be proportionate to its size and complexity
regardless of the relevant general legal requirements.
From the perspective of a prudential supervisor, the basic elements of a good corporate governance
framework could include the following:
- The primary responsibility for the conduct of the bank's business lies with its board and
management. Indeed, it is difficult to conceive that a bank could carry out activities in the
absence of strategic objectives or guiding corporate values. Therefore the responsibilities of
the board and management would include, among other things, approving ethical standards,
establishing and maintaining strategic objectives, policies and procedures as well as
ensuring that the bank complies with the statutory and supervisory obligations.
- Persons filling key roles should be expected to have the necessary skills and experience to
carry out their tasks appropriately. The supervisor has a role in assessing the qualifications
and integrity of these key personnel through fit and proper tests.
- Depending on the size and complexity of the bank, appropriate structures and control
mechanisms such as strong internal audit, external audit and the oversight function of the
board (directly or through supporting committees such as audit committees, risk committees,
compensation committees etc) support the effective operation of a supervised bank.
- Other elements, such as the appointment of independent board members who can exercise
objective judgement, are usually recognised as good practice.
Basel II and corporate governance
Let me turn now to the Basel II capital framework. I am asked to speak about Basel II quite frequently,
but while I am often requested to talk about the mechanics and the impact of the new framework, I am
seldom asked about its corporate governance aspects. This is unfortunate because, in my view, Basel
II is fundamentally about better risk management anchored in sound corporate governance. With that
in mind, I would like to focus now on three areas where I believe Basel II will contribute to more
effective corporate governance. I will refer to these as the three C's: controls, culture and clarity.
Controls
The first "C" is controls. A bank can use the most sophisticated measurement tools in the world, but if
it is poorly governed, it will be vulnerable to financial and operational weaknesses. The Basel
Committee recognised this when it developed the qualifications that banks must meet in order to adopt
the most advanced approaches under the first pillar of Basel II. The first pillar aligns minimum capital
requirements more closely with banks' actual underlying risks. Qualifying banks may also rely partly on
their own measures of those risks, which will help to create economic incentives to improve those
measures. This presumes, of course, that qualifying banks meet rigorous criteria related to the
governance of their risk management frameworks. While much attention has been focused on the
more complex quantitative aspects of the new framework, I believe the most important qualifying
criteria are those that address how the bank's risk management framework is governed.
Effective risk controls are essential to the successful implementation of the new capital framework.
Under Basel II, the board of directors is expected to establish the institution's risk tolerances, policies,
and code of conduct, and to ensure that a sufficiently strong risk control framework is in place. Senior
management, in turn, is responsible for implementing the risk control framework set forth by the board.
In addition, the framework sets out clear responsibilities for auditors and other quality control functions
to ensure that a bank's risk control framework is subject to effective independent review, oversight and
validation. The board needs to harness the work of the auditors as an independent check on the
information received from management. I believe that this emphasis on the role of the board and
senior management in developing and implementing an effective risk control environment will, with the
help of independent audit and other control functions, result in better-managed banks.
Culture
The second "C" is culture. I believe that the increased responsibilities of the board of directors and
senior management under Basel II will foster a culture of improved risk management. This notion
underlies the second pillar of the new framework, which takes as its starting point that the board and
senior management have an obligation to understand the bank's risk profile and ensure that the bank
holds sufficient capital against its risks. Supervisors, in turn, are responsible for reviewing the bank's
assessment to evaluate and determine whether that assessment seems reasonable.
The key, in my view, is that risk awareness starts at the top of the organisation. The board and senior
management cannot abdicate their responsibility to understand and manage the risks arising from the
bank's activities. I believe that this focus on sound risk management at the very top will help to set the
tone throughout the bank that effective risk management is everyone's job.
Of course, this may also represent a cultural shift for supervisors. Basel II places a firm emphasis on
taking a risk-based approach to supervision. As banks grow in complexity and sophistication, I believe
that it will be necessary for supervisors to place a greater emphasis on understanding banks' own risk
assessments. It is therefore vital that we complement the traditional accounting-based approach to
supervision with a greater emphasis on analysis of the risks affecting banks and the control systems
that banks have in place to mitigate such risks. This cultural shift may not be easy, but I believe it will
be beneficial not only for us as supervisors, but also for banks and for the stability of our financial
systems.
Clarity
The third "C" is clarity. I believe that Basel II will provide greater clarity regarding banks' measurement
and management of risk. This will be achieved first of all through the third pillar - market discipline -
which aims at ensuring that the market provides an additional layer of oversight. The third pillar is
intended to focus the board and senior management on heightening disclosure, which should
strengthen incentives for prudent risk management. Greater transparency in banks' financial reporting
should allow majority and minority shareholders, depositors, debt-holders, and other market
participants to evaluate banks and reward or penalise them according to how prudently they are
managed. This should provide a window on how the bank is governed, and should serve to curb
excessive risk-taking in advance.
Basel II will enhance clarity in other ways as well. Not only will banks be expected to improve their
external transparency, but they will also be expected to operate more transparently internally. In
particular, banks will be expected to ensure that the board of directors and senior management are
sufficiently well-informed to be able to meaningfully assess the bank's risk profile. This will place a
premium on effective and accurate risk reporting. Likewise, there is an expectation that senior
management will communicate effectively to employees their responsibilities with regard to the
effective management of risk.
Finally, Basel II will enhance clarity by promoting international co-operation between supervisors.
International banking organisations have grown increasingly complex over the years, to the point that
in some cases it can be very difficult for supervisors - and even for bank management - to have a clear
understanding of their global risk profiles. This highlights the need for effective supervisory
co-operation for such organisations. Effectively combining the necessary supervision at the local level
in the host country with effective supervision at the consolidated level in the home country requires
more thorough exchange of information and better knowledge of financial instruments and links within
financial groups. This will heighten supervisory understanding of banks' activities and will promote
consistency in the implementation of standards, a level playing field and the reduction of unnecessary
regulatory burdens.
Next steps
While I have focused my remarks on the new capital framework, I would like to emphasise that
corporate governance is much broader than Basel II. With this in mind, the Basel Committee has
established a Working Group to review the Committee's existing guidance on corporate governance
for banks.
This guidance was issued in 1999, and while the principles contained in it remain relevant, the
Committee believes that this is an opportune time to review them. First, the OECD last year issued
revised principles on corporate governance. Since the Committee's 1999 guidance drew upon the
original OECD principles, we felt that it would be appropriate to consider their revised principles as
well from our prudential perspective. Second, in light of the recent high-profile corporate governance
breakdowns that I highlighted at the beginning of my remarks, we felt that it was important to consider
whether there were any lessons to be learned that would apply specifically to our guidance for banks.
Finally, the Committee has asked the Working Group to consider whether it would be appropriate to
develop guidance on what I call "know your structure" elements.
While it is too soon to report on the Working Group's findings, they are expected to make
recommendations to the Basel Committee this summer. We hope to issue a draft of revised guidance
on corporate governance for public consultation in late summer or early fall. The IFSB has already
expressed an interest in this work, and I certainly encourage everyone here to review the draft
guidance when it is released and to send us your comments. We would like the guidance to be
relevant not only to Basel Committee member countries, but to non-member countries as well. We
would therefore value your feedback.
As we take our work forward in the Basel Committee, and as the IFSB conducts its own work in
preparing its exposure draft, I believe we would all benefit from keeping a sense of proportion. Clearly,
we cannot have the same expectations for the governance of a large, complex bank that we have for a
much smaller bank. When the Basel Committee issues supervisory guidance, we typically say that
supervisors' expectations should be commensurate with the size, complexity and risk profile of the
institution. That applies equally here. My hope is that we can raise the bar for the governance of the
banking industry as a whole, while concentrating our supervisory resources on the governance of the
most complex and sophisticated institutions.
Conclusion
I realise that I am all that stands between you and a marvellous gala dinner, so I will keep my closing
remarks very brief. I would just like to emphasise that sound corporate governance should be
considered a key element of a bank's ability to understand and manage its risks. As supervisors, we
should direct our resources to helping banks improve their controls, culture and clarity in respect to
risk management. In so doing, I believe that we will help achieve our objective of a stable and healthy
banking system that contributes to the proper functioning of the economy.
Thank you very much.