Muhammad bin Ibrahim: The challenges of corporate governance in the
financial services sector
Keynote address by Mr Muhammad bin Ibrahim, Deputy Governor of the Central Bank of
Malaysia (Bank Negara Malaysia), at the University Malaya's (in collaboration with the Asian
Institute of Chartered Bankers and the International Centre for Education in Islamic Finance)
Workshop on "The Challenges of Corporate Governance in the Financial Services Sector",
Kuala Lumpur, 6 August 2014.
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It is my pleasure to be at this workshop on the theme of "Challenges of Corporate
Governance in the Financial Sector". I would like to congratulate the University of Malaya,
the Asian Institute of Chartered Bankers and the International Centre for Education in Islamic
Finance for the joint effort to organise this event. I am also encouraged to see speakers from
the world of academia, the financial industry and the public sector congregate to offer
different perspectives on this important topic. My remarks today will touch on recent issues
relating to corporate governance standards with particular emphasis on the financial sector.
The growing emphasis on good governance
The motivation for strengthening corporate governance in the financial sector is
well-established. Unlike other industries, the financial sector plays an important intermediary
role that relies heavily on public trust and confidence. Being highly visible entities, any lapse
or failure in the governance of financial institutions, whether real or perceived, would attract
adverse public reaction and could severely affect their reputation and public confidence. The
failure of a systematically important financial institution may also result in serious
ramifications and costs to the economy, given their roles and inter-linkages within a country's
economy. For this reason, especially in the conduct its business operations, financial
institutions are subjected to a higher standard of integrity and professionalism. In recognition
of this, statutory responsibility is entrusted to the board and senior management to steer the
institution and to safeguard its safety, integrity and reputation at all times. As public interest
entities, actions by financial institutions have far reaching implications for a wide range of
stakeholders.
Modernising corporate governance for the banking sector and the insurance industry has
been a major focus for Bank Negara Malaysia following the Asian financial crisis in 1997. In
the years since then, various regulatory reforms have been implemented to strengthen board
practices, roles and responsibilities. These reforms include requiring the establishment of
board committees, enhancing the independence of the board, expanding transparency and
raising disclosure requirements. We also commissioned a study on board remuneration with
the aim to improve board remuneration packages and as a way to retain and attract fresh
board talent.
At the international level, more expanded efforts were undertaken to strengthen corporate
governance in the financial sector in 2008 following the global financial crisis. It became
evident that ineffective boards and weak senior management oversight had been key
contributing factors to the failure of some of the largest global financial institutions.
Conversely, institutions that performed better or were able to weather the crisis were those
with a reputation for prudence, sound corporate governance and risk management practices.
At the international level, the Basel Committee on Banking Supervision updated its guidance
on Principles for Enhancing Corporate Governance in 2010. This update followed the
Committee's decision to revisit the 2006 guidelines in the wake of the financial crisis. The
updated guidance reaffirmed the continued relevance and critical importance of the existing
principles and highlighted the key areas which merit the most focus. These include the
monitoring of risks on a firm-wide and individual entity basis. The guidance also emphasised
the board's oversight of compensation structures. Earlier this year, the OECD launched a
review of its Principles of Corporate Governance. The review, the first since the standards
were updated in 2004, was commissioned to take into account developments that have taken
place in the corporate sector and capital markets.
In Malaysia, the Securities Commission launched the Corporate Governance Blueprint in
2011 which outlined the strategic objectives for strengthening market discipline among
capital market participants. One of the deliverables of the Blueprint was the publication of a
revised Malaysian Code on Corporate Governance in 2012. A key feature of the Code is the
emphasis on the role of directors and the need for a strong board composition.
Within the financial sector, the foundations for corporate governance have been further
strengthened with the enactment of the Financial Services Act 2013 and Islamic Financial
Services Act 2013. The functions and collective duties of boards of directors, and the fit and
proper requirements for key responsible persons, are now clearly encoded in law. Boards of
directors are now required by statute, when making decisions, to consider the interests of
various stakeholders such as depositors, investment account holders, insurance policy
owners and takaful participants. The new legislations also provide Bank Negara Malaysia
with enhanced powers to take pre-emptive supervisory interventions against financial
institutions to mitigate the risks of governance failures.
Following these changes in the law, existing corporate governance standards that are
applicable to financial institutions are also being reviewed by Bank Negara Malaysia. The
review would reflect the higher expectations demanded of the industry given the importance
of the financial system to the economy. The review will elevate some of the existing industry
"best practices" to become minimum standards for all financial institutions. Bank Negara
Malaysia considers these enhancements as necessary, given the greater sophistication and
higher level of maturity of the financial institutions and the financial system. We expect that
the revised set of corporate governance standards would be issued for consultation by the
end of the year.
The challenges and the imperatives
The governance of institutions remains a complex subject despite the many advancements
that have been made over the years. This complexity stems from the highly dynamic and
constantly evolving nature of the financial system. Financial institutions occupy a unique
position in any economy. This uniqueness requires financial institutions to balance between
growth, profitability and innovation, and the long-run stability of institutions. It is also this
unique position that may create a moral hazard where financial institutions are incentivised to
take excessive risks on the expectation that the cost of failure would be borne by a third
party, for example through government bail outs or through the concept of "bail-in". This state
of affairs, if not managed appropriately, would burden the taxpayers and increase the
dissatisfaction of the general public with the industry.
The risks and trade-offs that I have mentioned would pose a number of specific issues and
challenges for corporate governance.
Firstly, the complexity of the operations of financial institutions and financial groups is
expected to continue to increase. Financial institutions are becoming larger and more
complex as they grow in size and expand abroad. Earlier this year, the six domestic banking
groups had overseas operations in 22 countries worldwide, including in all ASEAN member
countries. The total overseas assets of the domestic banking groups had also increased by
15.4% from the previous year to RM362.1 billion. The oversight of financial groups with cross
border operations is more complex and demanding, as groups have a highly diverse range of
businesses, products and services, and diversified clientele bases. Managing people with
different cultures will be an additional challenge. In some instances, the board and
management will also have to deal with increased and sometimes conflicting regulatory and
legal requirements across the different jurisdictions. For such financial groups, the lines of
accountability and reporting must be clearly established to avoid the business becoming
"toobig-to-manage". A more diverse board reflecting the financial group's cross border presence
might also be necessary. As the operating environment becomes more complex, it is not an
impossibility that sometime in the near future there would be a demand for "professional
directors".
Secondly, financial innovation, including in the area of Islamic finance, will continue to
expand as institutions seek their own competitive edge. While we should encourage such
innovations within the bounds of prudence, the implication of financial innovations on
governance arrangements and practices must be properly understood. For example, the
introduction of new financing structures based on different Islamic contracts such as
equitybased or risk-sharing concepts will likely demand different and more robust governance
arrangements. In this context, the Bank is introducing Shariah and operational standards to
promote greater legal and operational certainty and quality in Islamic finance transactions.
These standards will set out, among others, clear duties and responsibilities of the various
parties involved in Islamic contracts with the aim to ensure end-to-end Shariah compliance.
At the same time, there will be enhanced disclosure requirements on risks associated with
potential misconduct and negligence. In such circumstances, we expect the board to provide
leadership, guidance and oversight in ensuring that the needs and rights of all parties are
adequately and appropriately managed.
Thirdly, the implementation of global regulatory reforms will pose further challenges for the
industry. While the reforms are well-intended, the complexity and impact of the reforms to
business should not be underestimated. Increasingly, there seems to be a trend on the
"extraterritorial" application of laws and regulatory requirements, which have implications on
other jurisdictions. The extraterritorial effect of such laws may require changes to existing
practices and may involve substantial costs in terms of system change and improving
monitoring capabilities. At the board and senior management levels, an adequate
understanding of the potential impact of these trends and regulatory changes is critical to
help the organisation in setting business priorities while ensuring full compliance with
emerging regulatory requirements.
With much at stake, board members must take seriously their responsibility to drive the
corporate governance agenda forward. One important lesson we ought to learn is that weak
governance causes the failure of financial institutions. The costs of salvaging a failed
institution far outweigh the costs incurred to prevent such a failure. Over the long term, the
failure of institutions would also cause businesses and households that depend on financial
institutions for funding to be in a difficult position, erode public trust that would take many
years to restore and consequently result in more intrusive and prescriptive regulation of the
industry.
As stewards of financial institutions, boards and senior management bear the responsibility
of ensuring that regulatory policies translate into operational practices. Rules must be
embedded into the day-to-day business and operations that suit an institution's business
environment. Good corporate governance will not emerge from mere compliance with
regulatory checklists as each financial institution is different and unique. With careful
introspection, each individual institution needs to continuously reflect on whether its
governance arrangements, practices and business models are effective and still relevant. In
doing so, each institution must continuously assess and take into consideration the nature,
scope and scale of its business. In some instances, conventional and proven governance
approaches might not work anymore and therefore new thinking and methodologies are
required.
Real change cannot be dictated by regulation alone. This is neither sustainable nor possible.
Instead, principles of good governance need to be deeply woven into the fabric - or DNA - of
an organisation. Directors and senior management, as leaders of financial institutions, are in
the position to foster a positive organisational culture. The board and senior management
should work in harmony to cultivate an environment which appropriately balances between
performance and stability. For instance, the structuring of remuneration schemes should
reward long-term performance and encourage sound risk-taking. There should always be a
balance between financial innovation and excessive risk-taking. While an equilibrium is not
easy to attain, it cannot be achieved accidentally. But an equilibrium can be realised through
careful design, taking into consideration an institution's internal structures and behavioural
norms.
Needless to say, the accepted behaviour and values promoted and demonstrated by the
senior leadership will influence the business culture and values throughout the organisation.
Talking about cultures and values, we should also be mindful about the need to educate and
instil into the new generation of bankers the importance of integrity, ethics and
professionalism. For this reason, industry training institutes like the recently established
Asian Institute of Chartered Bankers play a vital role in cultivating higher standards of
governance, ethics and professionalism in the financial sector. The importance of the
contributions by these institutions cannot be underestimated. After all, graduates starting off
their careers in the financial sector will be the leaders and captains of the industry in years to
come.
Good governance ultimately depends on the existence of strong and competent boards and
a pool of professional senior management. To remain effective, boards are often confronted
with the challenge of achieving an optimal balance between the need for continuity and the
need for fresh perspective. This brings into question the issue of board composition and
membership, and how talent on boards should be continuously renewed. Because financial
institutions are complex creatures, longer-serving individual directors can bring a depth of
knowledge and experience into the business of the financial institutions, which would
consequently strengthen the ability of the board to provide effective oversight. Such
continuity also encourages a cohesive board. However, if not balanced appropriately, this
can also lead to complacency and "groupthink", and as a result, the institution would remain
stagnant and uncompetitive. Identifying and searching for new directors who are up to the
task of governing complex financial institutions is not easy and takes time. It is due to these
factors that the board needs to adopt a proactive and rigorous approach in the matter of
board renewal and succession.
Balance also needs to be achieved in the incentive structures for financial institutions' board
of directors. We are all aware that recent legal and regulatory developments in corporate
governance have significantly raised the responsibilities and potential liabilities of board
members. In order to attract and retain the right talent, it is essential to develop an
appropriate remuneration package that is commensurate with the heavier and expanded
responsibilities of directors. Similarly, financial institutions engaging in Islamic finance should
also include a review on the remuneration of their Shariah committee members with the aim
to attract and retain the best talents.
But having an attractive remuneration package as described above is not enough. Having a
dedicated budget for the development and training of directors will also be crucial in helping
them to acquire new knowledge and skills that enable board members to effectively
discharge their duties and responsibilities. In a complex and fast changing environment,
individual directors need to remain apprised of emerging trends within the industry and
economy. Experiences accumulated over the years will no doubt help directors in
discharging their roles and responsibilities. However, this will count for nothing if directors do
not and cannot adapt to the dynamic nature of the banking and economic environments.
It is for this reason that Bank Negara Malaysia, in collaboration with Perbadanan Insurans
Deposit Malaysia, introduced in 2008 the Financial Institutions' Directors Education
Programme or better known as the FIDE programme. Since its inception, the FIDE
Programme now offered under the ICLIF Centre for Governance and Leadership has
provided customised training on corporate governance practices to more than 500 directors
of financial institutions in Malaysia. This programme has had an important role in catalysing
positive changes in how boards and senior management function and interact, thereby
improving the overall quality of financial institutions' governance. It is also through this
programme that a directors' network has emerged, enabling peer learning, and the sharing
and exchange of experiences among financial institutions directors.
Role of stakeholders
In elevating the standards of corporate governance in the financial services industry,
shareholders play an important role to engage boards and hold them to account. Demands
for improvements in corporate governance could be driven by the institutional investors and
minority shareholders. But for this to happen, they require relevant information on the
financial institutions performance and operations.
In this context, the Bank has outlined proposals in the Financial Sector Blueprint to require
periodic audits of corporate and Shariah governance to help investors better understand
whether disclosed governance arrangements are reflected in actual practice. This will
supplement the role of existing disclosure requirements which help investors assess the
financial condition and risk profile of financial institutions.
Conclusion
It is my hope that as we venture into the future, this workshop will steer a dialogue towards
developing a deeper understanding of the contemporary issues that confront the industry and
yield new perspectives and insights around governance issues. Programmes such as this
make an important contribution to that process.
On that note, I wish you a productive and engaging workshop.