Shamshad Akhtar: Corporate governance for banks
Speech by Dr Shamshad Akhtar, Governor of the State Bank of Pakistan, at the IBP
Convocation, Lahore, 13 March 2008.
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This morning I propose to share with you my thoughts on the topical issue of "Corporate
Governance for Banks". Corporate governance revolves around the basic principles of
fairness, transparency and accountability. Contrary to the perception of many, good
governance is not a new phenomenon - the concept of well governed companies has been
there ever since formal businesses took over the barter trading system. "Corporate
Governance" received fresh impetus and widespread recognition during the 1990s with
launching of the Cadbury Report in the UK and prognosis of East Asian Crisis of the late
1990s and a series of corporate scandals in West including the Enron Scandals. Together
the loss of investor confidence and economy generated by the corporate failures brought to
forefront the significance of corporate governance. Global and regional debates and
initiatives have helped promote greater fairness, transparency and accountability, though
there remains scope for still better understanding of its dimensions and effective
implementation.
Corporate governance is critical to improving economic efficiency and growth. It serves as a
deterrent to mismanagement and infuses discipline in the decision making process of boards
of directors. Adherence to the principles of good corporate governance serves to foster
investor confidence and attract domestic as well as foreign investors. Companies operating
on the principles of good corporate governance are able to attract investment. A study
conducted by McKinsey quarterly indicated that investors would be willing to pay as much as
30 percent more for shares in companies having effective corporate governance. A number
of surveys of investors in Europe and the US support the same findings and show that
investors eventually reduce their investments in a company that practices poor governance.
Why corporate governance matters for banks?
The need for corporate governance in Pakistan is unmistakable. The country has steadily
responded to the corporate governance challenges and progress in the banking sector is
particularly impressive. Before we consider the corporate governance reforms for banks and
the outstanding agenda, let us first explore why corporate governance matters for the
banking system!
Most importantly, the financial system in Pakistan continues to be predominantly
bankbased, with bank assets to GDP ratio of 58.8 percent for 2007. Good corporate governance
for banks, therefore, becomes critical in ensuring solvency and stability of the financial
system as effectively governed banks are more efficient and prudent in directing their
resources.
Secondly, banks are highly-leveraged: they lend money borrowed from depositors and must
therefore be accountable to these depositors. The corporate governance framework should,
therefore, ensure aligning the interests of the management with equity and debt holders. The
corporate governance of banks is intricately tied to the corporate governance of firms with
former enforcing discipline through proper due diligence of conduct of corporate and their
financial, while proper governance at corporate level help in safeguarding bank's interests.
Thirdly, ownership and group structure of banks in Pakistan is highly varied. The banking
sector comprises of foreign-controlled, family-owned and some state-owned banks, with
each type of ownership structure posing its peculiar governance challenges. Moreover, some
banks operate as part of industrial/commercial groups while a large number of them have
exposure to the non-bank financial sector through ownership and control. In such a scenario,
transparency and fairness in banks' lending and investment decisions, particularly those
concerning group companies, becomes a crucial requirement.
Finally, banks need to adopt good governance practices and customer service standards in
order to build public confidence in credibility of their operations. Banks operate in a highly
vulnerable environment where bonafide or perceived impression of malpractices in a bank's
dealings could trigger a run on its deposits.
Role of SBP
SBP has been on the forefront in promoting good corporate governance in the country.
Primarily as the regulator and supervisor of banks and DFIs, SBP has a crucial role in
steering corporate governance reforms in the banking sector. In this regard, SBP has
implemented a comprehensive corporate governance regime for banks, which is driven by a
robust legal and regulatory framework, risk-based supervision and over-arching banking
sector reforms, notably, privatization, liberalization and consolidation of banks.
The major thrust of legal and regulatory requirements is to strengthen the functioning of the
Boards of directors of banks. In setting out the responsibilities of the Board, SBP requires
directors to focus on policy making and general direction, oversight and supervision of the
business of the bank. The directors are expected to meet frequently, set up Board
committees for audit, risk management, recruitment and compensation, and attend training
programs to help them discharge their role as a director.
In a recent move, SBP has separated the positions of chairman and CEO of banks and made
it mandatory on banks to appoint on the Board at least 25% independent directors and not
more than two executive directors. SBP has also strengthened the fit and proper criteria and
approves appointment of directors and CEO of banks in line with the criteria. Banks must
also follow the fit and proper criteria in appointing key executives although such
appointments do not require SBP approval.
Recognizing the centrality of proper risk management in corporate governance framework,
SBP has issued guidelines on risk management, internal controls, IT security and business
continuity planning. Detailed instructions are available in the policy framework for banks. Risk
management framework is laid out in the regulatory requirements that check banks'
exposure to group companies and other related parties, restrict exposure to single borrower,
borrowing group or sector, as well as limit banks' investments in equity market. Key
requirements in this regard are:
(i) Shareholding by a bank/DFI in other companies has been restricted to 30 percent of
the other company's paid up capital or 30 percent of the paid up capital and
reserves of the acquiring bank/DFI, whichever is lower. (Section 23 (2) of BCO)
(ii) Banks/DFIs have been restricted from taking unsecured exposures on their
directors, major shareholders, CEO, their families and firms or companies in which
such persons have interest. In case a secured exposure is to be taken, it shall
require prior approval of the Board of directors, excluding the director concerned,
and the facility shall be extended by the bank at prevailing terms and conditions, on
an arm's length basis.
(iii) Standard limits at 30 percent and 50 percent (including 20 percent and 35 percent
for fund based exposure) of bank's/DFIs' equity apply on single and group
exposures, respectively. Furthermore, contingent liabilities of a bank/DFI should not
exceed 10 times its equity. Likewise, clean lending to single persons is limited to Rs.
0.5 million while aggregate exposure against all clean facilities should not exceed
the equity of any bank/DFI. SBP has also specified that banks'/DFIs' exposure to a
company cannot exceed 10 times of borrowing entity's equity and the borrower's
current ratio cannot be lower than 1:1.
(iv) Banks/DFIs should not invest in shares of any company/scrip in excess of 5 percent
of their equity. Banks/DFIs will require prior approval from SBP in order to purchase
shares of a company in excess of 5 percent of their paid-up capital or 10 percent of
the capital of the investee company, whichever is lower. Furthermore, aggregate
investments of banks in shares should not exceed 20 percent of their equity. Any
shares acquired in excess of 5% limit due to underwriting commitments must be off
loaded within a period of three months.
(v) Banks/DFIs may also take exposure in future contracts to the extent of 10 percent of
their equity on aggregate basis. In this connection, the 10 percent exposure limit for
future contracts will include both positions taken in futures buying and selling.
To strengthen further risk management framework, SBP like other countries is steering the
implementation of Basel-II in a phased manner. Initially banks are required to adopt the
Standardized Approach for credit risk and the Basic Indicator/ Standardized Approach for
operational risk from 1st January 2008. Subsequently, once they have improved their in
house systems, they would have the option to switch over to more advanced approaches
from 1st January 2010 subject to the adequacy of capacities and capabilities and its due
diligence by SBP.
As a further step to strengthen governance of banks, they are required to undergo credit
rating annually. The rating must be announced publicly and disclosed in the financial
statements of the bank.
SBP also requires banks to appoint auditors from a panel of pre-approved auditors
maintained by it. The objective is to ensure credibility of audited financial statements of
banks.
In the area of monitoring and supervision, SBP has implemented a comprehensive
framework, which is underpinned by regular on-site inspections of banks and DFIs under the
regulatory ambit of SBP. Banks are inspected in accordance with a pre-approved annual
inspection plan, following the CAMELS-S1 approach. SBP has also developed a
comprehensive surveillance mechanism - the Institutional Risk Assessment Framework
(IRAF) - to capture the host of risks facing individual banks based on the information
gathered from on-site inspections, off-site supervision, market intelligence and
selfassessment by banks. The objective is to obtain a composite rating for each bank for
effective and proactive supervision by SBP.
Finally, SBP is endeavoring to further strengthen its own governance processes in
consultation with its Board of directors. An adequate and appropriate governance framework
is crucial for the optimal functioning of any enterprise, but more so for a central bank
because of its objectives of maintaining price stability and ensuring financial stability along
with its crucial contribution to the overall economic policy framework. Furthermore, a vibrant
and effective regulator is able to carry forward the corporate governance reform process
more rigorously.
SBP is fully cognizant of the need to implement good governance practices in its own
functioning and has empowered its Board of directors to provide oversight and direction of
affairs and business of SBP. In order to modernize SBP's operational strategies and
strengthen its governance, the organization has been successfully restructured in 2006,
followed by adoption of market-driven compensation packages for its employees in 2007.
The focus of the SBP management has been on improving risk management and internal
controls systems within the organization as well as enhancing transparency in its
communications on policy and financial sector issues. SBP is also working towards
developing adequate policy framework for consumer protection and has set up a Consumer
Protection Department to safeguard consumer interests.
Impact of corporate governance reforms
Pursuant to multiple reforms initiated for the purpose, there has been a visible improvement
in the corporate governance practices of banks. The fundamental change is in the
effectiveness of the board. The implementation of Fit and Proper criteria has ensured that
board members are well equipped to carry out their responsibilities. The criteria is also a
measure to exclude unscrupulous individuals from the highly responsible position of a board
member, In terms of performance, the Boards of directors now meet more frequently,
focusing largely on strategic objectives and management oversight. The scope of the Board's
policy making function has enhanced to cover a broad range of areas, such as systems and
control, risk management, human resources, credit, investments, etc.
Professional management is appointed to carry on the banks' operations. Furthermore,
internal control system has been strengthened in banks through setting up of audit
committees and internal audit functions. Compliance officers are now appointed to manage
banks' compliance to the policy framework and laws and regulations, including the AML
requirements.
The frequency of financial reporting has improved through circulation of quarterly accounts.
Financial reporting standards are at par with international best practices while credibility of
financial information has received a boost through rotation of auditors after every five years.
Enhanced disclosure has positive implications which go beyond just accounting statements
of the banking entity. It is a mechanism for the market to assess the quality of assets, and
earnings, and expose any hidden risk, for example those arising from associates,
subsidiaries, related parties lending etc.
These improvements have been reflected in international assessments of corporate
governance framework in Pakistan. The ROSC-CG assessment of Pakistan in June 2005
acknowledges that "Reform to improve corporate governance has been significant, including
the introduction of a Code of Corporate Governance and increased vigilance by regulators."
The ROSC-CG assessment further notes that "The SBP has also been instrumental in
improving corporate governance in the banking system, by requiring banks and DFIs to
adopt the Code, and by assessing compliance with other relevant aspects of prudential
regulation specifically applicable to banks/DFIs." Similarly the World Bank's 2007 report on
Doing Business in South Asia recognizes that "Pakistan provides relatively strong protections
for minority shareholders against the misuse of corporate assets". It ranks 19th worldwide on
protecting investors.
Outstanding corporate governance reform agenda
While considerable progress has been achieved in enhancing corporate governance
practices of banks, SBP is geared towards filling in the remaining gaps.
In this regard, foremost is the need to develop a suitable cadre of professional directors who
are knowledgeable of banks' affairs as well as independent of their management and
majority shareholders. Allied to this is the need to clarify and strengthen directors' fiduciary
duties to act in the interests of the bank and all of its stakeholders. It is also essential for
banks to provide sufficient time and information to directors to prepare for Board meetings,
structure Board meetings so as to allow ample time for discussion and establish appropriate
criteria for assessing and improving performance of directors, including independent
directors. To raise awareness on these and related aspects, SBP is working towards issuing
comprehensive corporate governance guidelines for banks.
As earlier discussed, Pakistan's corporate and financial sectors present corporate
governance issues peculiar to complex ownership and group structures. By conducting
operations through a complex network of subsidiaries, controlling shareholders often acquire
control of operations and/or cash flows disproportionate to their equity stake in individual
companies. The key issues that arise as a result include: (i) inequitable treatment of
stakeholders; (ii) dominance of controlling shareholder-directors over Board proceedings; (iii)
lack of independence of the Board from the management; and (iv) channeling of bank
resources to the benefit of group concerns.
In order to address such corporate governance issues, there is a need for group supervision
by the regulators. As regard the banking supervision, SBP is working towards introduction of
consolidated supervision whereby it will not be monitoring banks as a stand-alone entity but
rather as part of the entire banking group. This will help to evaluate the strength of the entire
group and to mitigate risks arising from group companies. A significant component of
consolidated supervision will be review of group structures and detailed examination of
related party transactions.
I would also like to share with you that SBP has recently launched a survey of banks to
assess their corporate governance practices. The survey will help to identify areas for reform
in the regulatory framework as well as its implementation by banks. The survey results will be
a key input in further improving the corporate governance framework for banks.
Conclusion
Good corporate governance is essential in establishing an attractive investment climate
characterized by competitive companies and efficient financial markets. It is imperative that
Pakistan's banking sector develops and implements good governance practices, in order to
provide impetus to economic growth. In the realm of a rapidly globalizing world -
characterized by liberalization of markets, relatively free-er trade, sophistication of financial
products and instruments, and growing awareness among consumers - Pakistan is ripe with
lucrative opportunities for foreign and local investors alike.
I would also like to mention that no amount of regulatory intervention can fully institutionalize
corporate governance unless Boards and senior management of banks appreciate the value
addition of corporate governance to their productivity and competitiveness. In this context,
banks should strive to build a reputation for honest and fair dealing while interacting with their
internal as well as external stakeholders. Ethics, transparency and the competition for
reputation, which are the cornerstone of good corporate governance, would invariably be the
distinguishing features of banks that emerge ahead in an increasingly competitive market.