Mr Carse: The importance of corporate governance in banks
Speech by Mr David Carse, Deputy Chief Executive of the Hong Kong Monetary Authority, at The
Year 2000 Millennium Dinner of The Association of International Accountants - Hong Kong Branch,
Hong Kong Bankers Club, Hong Kong, on 17 March 2000.
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Ladies and gentlemen,
I am very pleased to be here this evening to speak to the Association on the subject of corporate
governance in banks. I have chosen this as my theme both because it is highly topical for reasons that I
will explain later and because it should be of particular interest to this audience. The Association plays
an important role in the training and promotion of the accounting profession; and accountants are a
vital component in corporate governance not simply in their specific role as auditors but also as a
source of highly trained directors and managers.
I will begin by giving you a brief situation report on the banking sector because this is relevant to the
governance issue. Clearly, the situation is looking a lot better than it has done for the last two years.
As the 1999 results released so far have shown, the performance of individual banks is by no means
uniform. Some have done a lot better than others, depending on such factors as the mix of their
business and where they are in the provisioning cycle. But the figures collected by the HKMA for the
local banks' Hong Kong offices show that, in aggregate, their pre-tax operating profits rose by about
15% in 1999. This compares with the decline of 33% that we saw in 1998. This improvement has been
supported by renewed growth in net interest income. Moreover, the aggregate bad debt charge of the
local banks showed little change in 1999, having increased by 335% in the previous year. It is true that
some banks were obliged to increase their provisions against Mainland related companies during the
course of the year. But the general trend in the latter part of 1999 was that the growth in new problem
loans began to slow down as the economy improved. This is supported by the figures for problem
loans in the final quarter of 1999 which we published recently. These show that the ratio of loans
classified as "substandard", "doubtful" or "loss" to total loans fell to 9.8% at the end of December,
compared with the 1999 peak of 10.3% at the end of September. At the risk of tempting fate it does
seem that the worst of the bad debt problems for Hong Kong banks is over. Certainly all the local
banks are expecting a significant reduction in the bad debt charge in 2000, which will give a boost to
profitability.
Can we say therefore that life for the local banks is getting back to where it was prior to the crisis? The
answer unfortunately has to be "no". We are certainly moving into calmer waters for the banks but
there are strong currents, and a few sharp rocks, underneath the surface. The fact is that the
competitive environment for banks in Hong Kong is changing radically as it is for all banks around the
world. The current competition in mortgage lending is a case in point. Banks are increasingly prepared
to lend at margins well below prime. We are getting to the point where it is becoming difficult to earn
an economic return from this business once funding costs and other expenses are taken into account. It
can be argued that this in part reflects the current excess liquidity in the market and that margins will
start to move up again as loan demand and the property market recover in line with the economy.
There is some truth in this, but it is difficult to see margins on mortgage business recovering too far.
Certainly they will not get back to where they were in the boom years before the crisis. There are too
many active players in the market, both domestic and foreign, to allow this to happen.
What this means is that the banks are going to have to work harder to earn a profit than they have done
in the past. They will have to do this at a time when the last stages of interest rate deregulation in
Hong Kong are taking place, starting in the middle of this year and finishing in the middle of 2001.
The impact of deregulation cannot be predicted with certainty but the likely impact will be to increase
funding costs and thus squeeze the net interest margin. The banks will therefore have to find ways to
generate income through new products and through new charging policies. You can expect fees for the
various banking services to rise in the deregulated environment. The banks will also be under greater
pressure to reduce costs through exploiting new delivery systems, re-engineering their processes and
better managing their risks.
Technology is at the heart of these issues. It is one of the main forces which is driving increased
competition and one of the main weapons that the banks are using to respond to competition. How to
harness the power of technology, and how to finance the necessary investment, constitute the main
strategic challenge facing banks in the world today.
This brings me to the main theme of the importance of corporate governance in banks. It will be the
responsibility of the board of directors and senior managers of banks to navigate the way through the
strategic challenges that I have described, and they must ensure that they have the capacity to do so.
Corporate governance is of course not just important for banks. It is something that needs to be
addressed in relation to all companies. The Financial Secretary recognized this by announcing in his
Budget speech that he had asked the Secretary for Financial Services with the assistance of the
Standing Committee on Company Law Reform to conduct a comprehensive study on corporate
governance in Hong Kong this year. The objective will be to plug any gaps in the corporate
governance regime and to become a benchmark in the region. Market bodies, professional
organizations and regulators will be asked to help in this task. Your own Association may be able to
contribute.
I do however believe that sound corporate governance is particularly important for banks. The rapid
changes brought about by globalization, deregulation and technological advances are increasing the
risks in banking systems. Moreover, unlike other companies, most of the funds used by banks to
conduct their business belong to their creditors, in particular to their depositors. Linked to this is the
fact that the failure of a bank affects not only its own stakeholders, but may have a systemic impact on
the stability of other banks. All the more reason therefore to try to ensure that banks are properly
managed.
It is true to say that banks in Hong Kong are already well managed by international and certainly by
regional standards. The fact that they survived the financial crisis in generally good shape is a
testament to this. However, during the financial crisis, the HKMA came across a few individual cases
where the board of directors did not perform as well as might be expected. And this, coupled with the
challenges that lie ahead, has led us to look at ways in which corporate governance among the banks
might be further enhanced.
If I could sum up our objective, it would be to try to reassert the role of the board of directors in banks.
While the day-to-day running of banks should certainly be left in the hands of the management, the
board must play a leadership role in approving the objectives, strategy and business plans of the bank,
monitoring the performance of management and ensuring that the internal control and risk
management systems of the bank are effective. The board must also make sure that the bank conducts
its affairs with integrity and in accordance with high ethical standards. The board is part of the system
of checks and balances that ensures that neither large shareholders nor management abuse their power
and that decisions are taken with the bank's best interests in mind. If the board does not play its full
part, a vacuum in leadership will be created. This vacuum may be filled by the shareholders becoming
directly involved in running the bank's affairs, or by the executive management acting more or less in
isolation. In either case, the board of directors is bypassed and checks and balances are lost.
The HKMA has recently issued for consultation a draft guideline for banks and other authorized
institutions which sets out what the HKMA expects of them in relation to corporate governance. The
guideline aims to establish minimum standards. It does not itself have the force of law, but failure to
adhere to the standards may call into question whether the bank continues to satisfy the criteria for
authorization laid down in the Banking Ordinance.
The draft guideline describes the general responsibilities of the board, the legal obligations of directors
and the use of auditors. It then goes on to specify detailed guidelines to which locally incorporated
authorized institutions are expected to adhere. Let me summarise these for you. While I will refer to
the guidelines in relation to banks, most of them are also applicable to restricted licence banks and
deposit taking companies.
• First, the board should ensure that the bank establishes policies, procedures and controls to
manage the various types of risk with which it is faced.
Altogether the HKMA has identified eight types of risk for the purposes of its supervision.
These are credit, interest rate, market, liquidity, operational, reputation, legal and strategic
risk. The board should approve the relevant policies while management should put them into
effect. It is important that the policies should not exist merely for form's sake - in other
words, just to keep the HKMA happy - but should dictate how the institution is actually run
in practice.
• Second, the board should ensure that the bank fully understands the provisions of section 83
of the Banking Ordinance on connected lending and establishes a policy on such lending.
While there are no indications that banks in Hong Kong are abusing the rules on connected
lending, there seems to be uncertainty among some banks as to how the rules work. We have
therefore recommended that the board should ensure that the bank fully understands its legal
obligations under the Banking Ordinance and establishes a detailed policy on connected
lending.
Third, the board should ensure that it receives the management letter from the external
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auditor without delay together with the comments of management.
We have specified that the management letter should normally be received within four
months from the year-end. Of course, this is not something that is totally within the control
of the bank. I would therefore put in a plea to any bank auditors in the audience to submit the
management letter without delay.
• Fourth, the board should maintain an appropriate level of checks and balances against the
influence of management and/or the shareholder controllers in order to ensure that decisions
are taken with the bank's best interests in mind.
The key issue here is the number of independent non-executive directors there should be on
the board of banks. We recommend a minimum of three to ensure that there is a sufficient
pool of independent directors to sit on the various committees of the board and to cover
absences.
Fifth, the board should establish an audit committee with written terms of reference
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specifying its authorities and duties.
We recommend that the audit committee should be made up of non-executive directors, the
majority of whom should be independent.
• Sixth, board meetings should be held preferably on a monthly basis, but in any event no less
than once every quarter.
The board can only fulfil its leadership role if it meets frequently enough and receives
sufficient information from management to be able to monitor the financial position and
performance of the bank.
• Seventh, individual directors should attend at least half of the board meetings held in each
financial year.
We fully recognize that the effectiveness of a director cannot be measured simply by
attendance at board meetings. But equally it is difficult for even the most competent
individual to make a contribution if he or she does not turn up for meetings in the first place.
• Finally, the HKMA will meet the full board of directors of each bank every year.
It is not the intention that the HKMA should participate in board meetings. Rather, we will
meet with the board with the aim of strengthening communication between the HKMA and
the board at the highest level. Among other things, this will give us the opportunity to give
the board first hand information on the major findings about the bank that emerged from our
onsite examinations and offsite reviews. It will also give the board the opportunity to convey
its views directly to us, for example on whether we are imposing too much of a regulatory
burden.
As a result of the consultation exercise, we have received a number of supportive comments. It is
difficult, after all, to argue against the principle that banks should be encouraged to raise their
governance standards. However, a number of concerns have also been voiced. I will not go into these
in detail, but some of the questions that have been raised are as follows: Is the HKMA interfering too
much in the way in which banks choose to manage themselves? Is too much burden being placed upon
the board, and upon non-executive directors in particular, in terms of establishing policies and
controls? Should there be a distinction between listed and non-listed banks? Is it right to place more
onerous requirements on banks compared with other companies, for example as regards the required
number of independent directors? And is it going to be possible to find sufficient independent
directors of the right quality?
I have answered some of these questions already in this speech. We do believe that banks are different
from other companies because they are looking after other people's money. From this point of view, it
does not matter whether the bank is listed or non-listed. We also believe that banks are exposed to
special risks compared with other companies, and that the board needs to ensure that policies are in
place to manage these risks. This is not to say that the board should actually formulate these policies
itself. That can be left to management. But the policies should certainly be approved by the board. As
to whether we are placing too much burden on the non-executive directors, it should be recognized
that being a director of a bank does involve heavy responsibilities. Moreover, the criminal sanctions in
the Banking Ordinance apply to all directors, whether they are executive or non-executive. We
acknowledge that it may not be an easy task to find non-executive directors with the right skills and
degree of independence. We have therefore reconsidered our original recommendations on the number
of independent directors to some extent, particularly in relation to restricted licence banks and
deposittaking companies, and we are prepared to give institutions which do not already comply more time to
do so if necessary.
Finally, on the complaint that we are perhaps being too intrusive, I would point to our statutory
responsibilities under the Banking Ordinance to ensure that institutions operate with integrity,
prudence and competence and that individual directors are fit and proper. Concern about corporate
governance falls squarely within these responsibilities. However, let me stress that this is not an area
where we would want to take a narrow legalistic position. We are anxious to work closely with the
banking industry to arrive at a mutually acceptable approach to corporate governance which is
appropriate to the particular circumstances of Hong Kong. We will be aiming to ensure that the final
version of our guideline embodies this approach.