Alan Bollard: Corporate governance in the financial sector
Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to The Annual Meeting of
the Institute of Directors in New Zealand, Christchurch, 7 April 2003.
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Corporate governance is now a topic of considerable interest to a large and expanding cross-section
of the community. It is obviously of fundamental importance to this audience, given that most of you
are company directors. It is also of interest to the Reserve Bank, in its capacity as supervisor of the
banking system. In this speech, I will discuss a number of themes relating to corporate governance,
with particular emphasis on the important role it plays in promoting a sound financial system.
Until fairly recently, corporate governance was not a topic that attracted much public attention. It was a
topic reserved for discussion in the Board room or in academic environments. However, recent events,
such as the Enron scandal and other corporate governance failures, have put corporate governance
on the front pages of our main newspapers. Although none of us welcomes this kind of adverse
publicity, it has nonetheless had beneficial effects. In particular, it has highlighted the important role
that corporate governance plays in a modern economy and the consequences of getting it wrong. And
it has strengthened the incentives for directors and policy-makers alike to reassess the structures
needed to produce high quality corporate governance.
In this address, I present a central banker's perspectives on a number of corporate governance
issues. In particular, I will:
• comment on the role that corporate governance plays in the financial system and wider
economy, and why it is important for economic growth and financial stability;
• highlight what I would regard as the key elements of sound corporate governance; and
• discuss the role that corporate governance plays in the Reserve Bank's approach to banking
supervision.
Before traversing these subjects, I think it would be useful to begin by defining what I mean by
corporate governance. In this address, I am deliberately using the term quite broadly to encompass
the systems and structures that a corporate entity has in place to oversee its affairs. This involves a
number of elements, including a clear understanding by directors of their company's strategic
objectives, structures to ensure that the objectives are being met, systems to ensure the effective
management of risks, and the mechanisms to ensure that the company's obligations are identified and
discharged. Although corporate governance involves many systems and structures, the heart of it lies
in the boardroom - a point I hardly need to stress with this audience.
It is self evident that sound corporate governance is essential to the wellbeing of an individual
company and its stakeholders, particularly its shareholders and creditors. We need only remind
ourselves of the many companies, both at home and abroad, whose financial difficulties and, in some
cases, ultimate demise have been substantially attributable to weak corporate governance. But sound
corporate governance is not just a vital factor at the level of the individual corporation. It is also a
critical ingredient in maintaining a sound financial system and a robust economy. And that is why
governments have taken such an interest in recent examples of corporate governance failures. It is
also why banking supervisors are placing greater emphasis on the role that corporate governance can
play in promoting financial stability.
In the financial system, corporate governance is one of the key factors that determine the health of the
system and its ability to survive economic shocks. The health of the financial system much depends
on the underlying soundness of its individual components and the connections between them - such
as the banks, the non-bank financial institutions and the payment systems. In turn, their soundness
largely depends on their capacity to identify, measure, monitor and control their risks.
In New Zealand, the two core components of the financial system are the registered banks - which
represent the vast bulk of financial system assets - and the payment system - which processes billions
of dollars of transactions each day.
Banks face a wide range of complex risks in their day-to-day business, including risks relating to
credit, liquidity, exposure concentration, interest rates, exchange rates, settlement, and internal
operations. The nature of banks' business - particularly the maturity mismatch between their assets
and liabilities, their relatively high gearing and their reliance on creditor confidence - creates particular
vulnerabilities. The consequences of mismanaging their risks can be severe indeed - not only for the
individual bank, but also for the system as a whole. This reflects the fact that the failure of one bank
can rapidly affect another through inter-institutional exposures and confidence effects. And any
prolonged and significant disruption to the financial system can have potentially severe effects on the
wider economy.
The payment system is also a critical component of the financial system. It contains the pipelines that
connect the banks and other financial intermediaries. And it provides the means by which vast
numbers of transactions - personal and corporate, domestic and overseas - are made each day. The
payment system involves many different components, including systems for settling large, inter-bank
and inter-corporate payment transactions, and systems for handling myriads of smaller transactions,
such as cheques, credit cards, direct debits and EFTPOS. Each system is managed by a payment
operator. Some are private companies owned by the banks, while others are under the management
of the Reserve Bank. Although these operators do not face risks of the nature that banks face - such
as credit risk, for example - they do have major operational risks. In particular, they need to ensure
that the systems for processing payments, the back-up arrangements, and the internal governance
structures are robust. A major operational failure in the payment system has the potential to cause
severe disruption to the financial system and wider economy. At its worst, a major payment system
failure would bring countless commercial transactions to an abrupt halt, impede the operation of
business in virtually all parts of the economy and fundamentally undermine investor and business
confidence.
The stakes are indeed high - hence the need for banks, other financial institutions and the payment
system operators to maintain systems to enable them to identify, monitor and control their risks. And
sound corporate governance is the foundation for effective risk management.
Of course, corporate governance is not just an essential ingredient for financial stability. It is also a
critical feature in the longer term performance of the economy. One could be forgiven for thinking
otherwise, given the emphasis placed in the news media and elsewhere on the role of government in
determining a country's economic performance. We frequently read and hear commentary suggesting
that the key to better economic performance lies in better government policy - be it fiscal policy,
monetary policy or structural reforms. To be sure, these are all important ingredients in shaping
economic performance. But I believe one of the key drivers of how well or poorly our economy
performs is where we invest our resources and how well we use them. By and large, the way we
allocate and use our resources is not determined by policy-makers in Wellington. It is largely
determined by the investment and management decisions of hundreds of companies. In turn, the
quality of these investment and management decisions substantially depends on the quality of
corporate governance in each company.
Therefore, corporate governance is clearly of fundamental importance, both at the level of the
individual company and for the financial system and economy as a whole. Unfortunately, to the
detriment of both financial stability and economic growth, we have seen too many examples of
corporate governance failures over the years, both in New Zealand and in many other countries.
Indeed, it is not an exaggeration to assert that many of the financial crises seen in recent years,
including in Asia, Russia and Latin America, can be attributed, in no small way, to fundamental
weaknesses in corporate governance and risk management.
In particular, we know that financial distress episodes in a number of emerging economies have been
caused, in part, by excessive exposure concentration, directed lending, lending to connected parties,
poor credit policy and inadequate management of foreign exchange risk. To a large extent, such basic
risk management failures reflect a breakdown in corporate governance. They reflect poor
management of conflicts of interest, inadequate understanding in the boardroom of key banking risks,
and poor oversight by boards of the mechanisms for managing their banks, such as risk management
systems and internal audit arrangements. In some cases, a lack of truly independent directors on the
boards of banks was also a significant factor in weakening the effectiveness of boards. And we know
that these problems were compounded by poor quality financial disclosures and ineffective external
audit. In some cases, the rigour of the external audit process has been impaired by a lack of auditor
independence, not least as a result of some audit firms performing a range of non-audit services for
their clients.
Of course, these kinds of corporate governance failures are by no means unique to the financial
systems of emerging economies. We have seen similar examples of corporate governance and risk
management failures contributing to financial system distress in a number of advanced economies,
including much of Scandinavia in the 1980s and, of course, New Zealand and Australia in the late
1980s and early 1990s. And I hardly need to draw your attention to the much more recent high profile
corporate governance failures in the United States, United Kingdom and elsewhere.
In order to address these kinds of problems, and to reduce the risk of future corporate governance
failures, much activity has been underway, globally and at the domestic level. The OECD has
produced a set of corporate governance principles that have become the core template for assessing
countries' corporate governance arrangements. Similarly, the Basel Committee on Banking
Supervision - the international standard-setting body responsible for establishing international banking
supervision principles - has distilled principles for corporate governance in banks. More recently, we
have had the benefit of corporate governance reviews in the United Kingdom, and many are now
reflecting on the implications of the recently enacted Sarbanes-Oxley legislation in the United States.
Closer to home, in Australia, there has also been considerable interest in corporate governance
issues, including the role of non-executive directors. And, of course, many countries have their own
national codes of good corporate governance, either developed by government or by the private
sector. New Zealand is no exception, with the Institute of Directors having issued a raft of very useful
guidance material to directors.
There are few absolute "rights" and "wrongs" in the field of corporate governance, but some key
principles stand out. In particular, let me highlight a few basic principles to which we in the Reserve
Bank attach considerable importance in a banking sector context.
• First, I would particularly stress the importance of directors having a sound understanding of
their company's business, the nature of its risks and its strategic direction. This provides the
foundation for the sound management of any company. It is absolutely crucial in a bank.
• Second, we firmly believe that the ultimate responsibility for ensuring that a company's risks
are being properly identified, monitored and controlled lies in the boardroom.
• Third, we place considerable emphasis on the importance of having an adequate
representation of non-executive and independent directors on the board, and a clear
separation of the position of board chairman and chief executive officer.
• Fourth, it goes without saying - but I will say it anyway - that there is a fundamental need for
directors to be scrupulous in ensuring that, individually and collectively, potential conflicts of
interest are avoided or at least managed in ways that do not compromise the interests of the
company.
• We also stress the importance of rigorous internal and external audit arrangements - where
the external auditor has a strong measure of independence and is not conflicted by having
other significant financial interests in the company.
• Finally, as the Governor of a central bank that has placed strong emphasis on disclosure by
registered banks, and which sets high standards on its own financial disclosures, it will not
surprise you to know that we stress the importance of regular, timely, comprehensive,
meaningful and reliable financial disclosures of a company's affairs.
These kinds of principles feature strongly in the Reserve Bank's approach to the supervision of banks
in New Zealand. Before going on to explain our approach, and the central role that banks' corporate
governance plays in our framework, it may be useful to set the scene by highlighting the key features
of the New Zealand financial system. Some of them have particularly interesting implications for
corporate governance.
The New Zealand banking system is relatively unusual by international standards in a number of
respects. First, unlike the financial systems of many countries, in New Zealand the banks form a very
dominant part of the financial sector. Registered banks, of which there are currently 18, represent the
lion's share of the total financial system, both in terms of total financial system assets and deposit
liabilities. In terms of financial system stability, registered banks are by far the most important players
in the financial system. And of the 18 registered banks, only about 5 banks could be regarded as
systemically important, together holding more than 80% of total registered bank assets.
The New Zealand banking system is also unusual in another way - the nature of its ownership. All but
two of the registered banks are foreign owned, with the two New Zealand-owned banks being very
small relative to the system as a whole. The foreign-owned banks operate either as subsidiaries or as
branches of foreign banks, with most of the largest banks being wholly-owned subsidiaries of
Australian and British banks. As I will note later in this speech, this raises particular complications for
the nature of the corporate governance arrangements in these banks and raises interesting policy
questions for the Reserve Bank as guardian of the financial system.
As I have indicated, a fundamental component of New Zealand's approach to the promotion of
financial stability is the emphasis it places on the importance of corporate governance as a means of
encouraging banks to effectively identify, monitor and manage their business risks. This approach
recognises the critical role which directors have in overseeing the stewardship of their bank. Indeed, it
is worth noting that the New Zealand banking supervision framework, with its heavy emphasis on
encouraging sound risk management through strong corporate governance arrangements, is
somewhat unusual by international standards. In most countries, the standard approach to banking
supervision involves reliance on prudential regulation of banks, where a bank's risk positions are
substantially constrained by regulatory limits imposed by the supervisory authority. It also typically
involves some form of on-site examination of banks by the supervisors.
In contrast, the New Zealand supervisory framework quite deliberately avoids the use of prudential
regulation - except in limited areas, such as minimum capital ratios and limits on lending to related
parties. And the Reserve Bank does not conduct on-site examinations of banks. Our supervisory
framework is deliberately light-handed in nature, in the sense that we minimise our intrusion into the
management of banks' risks and the structure of their operations. Instead, we try to foster robust "self
discipline" in banks through the corporate governance and disclosure frameworks we have
established. That said, I should make it clear that, although the Reserve Bank does not conduct
on-site examinations of banks' loans and risk management systems, we do meet annually with the
senior management teams of the banks. These meetings provide an important opportunity to discuss
recent developments in the respective banks, risk management, banking industry issues and other
relevant matters. The meetings keep us well informed about each of the banks and the banking
industry as a whole, but fall well short of the more intrusive bank examination process typical in other
countries.
We also differ from many other countries by not having deposit insurance or an explicit depositor
protection objective. The statutory objectives of banking supervision in New Zealand are to promote a
sound and efficient financial system and to avoid damage to the financial system resulting from a bank
failure. We are not charged with protecting depositors or other bank creditors per se.
We believe the New Zealand approach is an effective way of promoting a sound financial system. We
also believe it reduces the moral hazard risks associated with conventional banking supervision, and
strengthens the effectiveness of market discipline on banks. The fact that the New Zealand banking
system is currently one of the healthiest in the world - with high asset quality, sound risk management
practices and good capitalisation - bears testimony to this. However, we are certainly not complacent,
and we remain ever-watchful to detect incipient signs of financial distress, and we stand ready to
intervene if necessary. Moreover, we regularly review our supervisory framework to ensure that it
continues to be an effective means of promoting a sound and efficient financial system. In that context,
we are currently reviewing a number of our supervision policies, with a view to further improving the
existing arrangements.
Although some of you will already be au fait with the mechanisms that the Reserve Bank uses to
promote strong corporate governance and risk management in banks, it is probably useful for me to
briefly summarise the main features. These policies include comprehensive disclosure requirements
for banks, a requirement for bank directors to attest to the veracity of their bank's disclosures and to
make attestations on the management of risks, and requirements in relation to the composition of the
board of directors. Let me elaborate briefly on these features:
All banks in New Zealand are required to publish comprehensive financial and risk-related disclosures
on a quarterly basis, including information on a bank's and banking group's:
• capital position;
• concentration of credit exposures to individual counterparties;
• related party exposures;
• asset quality and provisioning; and
• interest rate, exchange rate and equity risks.
Each disclosure statement is required to contain a number of attestations, signed by each director.
These are intended to encourage directors to focus their attention on key risks within their bank and to
be satisfied that these risks are being effectively managed.
Directors of each registered bank are required to attest that the bank has systems in place to monitor
and control adequately the banking group's material risks and whether those systems are being
properly applied at all times. The directors are also required to attest that all prudential requirements
applicable to the bank in question are being complied with, such as requirements relating to minimum
capital adequacy and exposures to related parties. And the directors are required to confirm that
exposures to related parties are in the best interests of the banking group.
Each bank director is required to sign their bank's disclosure statement and to certify that disclosures
made are not false or misleading. If a disclosure statement is found to be false or misleading, directors
are subject to potentially severe legal penalties, including substantial fines and imprisonment. In
addition, directors may face unlimited personal liability for creditors' losses where creditors relied on a
bank's disclosure statement that was false or misleading.
Banks incorporated in New Zealand are required to have a minimum of two independent directors,
who must also be independent of any parent company or other related parties, and a non-executive
chairperson. These requirements are intended to increase the board's capacity to exercise appropriate
scrutiny over the performance of the management team. In addition, independent directors provide
some assurance that the bank's dealings with its parent or other related parties are not in conflict with
the interests of the bank in New Zealand.
Complementing these requirements, New Zealand's approach to financial sector regulation seeks to
create an environment conducive to robust market disciplines. This is achieved through a number of
measures, including the promotion of a relatively open, contestable banking sector, a competitively
neutral approach to regulation - enabling banks and non-banks to compete on largely equal terms -
and the absence of deposit insurance. In addition, the Reserve Bank's approach to responding to a
bank failure stresses the importance of being able to manage a bank failure in ways that avoid the
need for a government-funded bail-out, and seeks to ensure that shareholders, subordinated creditors
and senior creditors, including depositors, bear their fair share of losses. All of these features are
intended to strengthen the incentives for market scrutiny of banks and to further encourage the
directors and managers of banks to ensure that their banks' risks - especially credit risk, market risks,
exposure concentration, operational risk and liquidity - are being prudently managed.
We are confident that these measures have been successful in contributing to a sound banking
system. But we have recently sent a comprehensive questionnaire to the boards of all banks to
develop a greater understanding of the means by which directors satisfy themselves that their banks'
disclosures are not false or misleading and that their systems for controlling risks are robust. We will
be very interested to see the results of that survey and then to assess whether the existing
arrangements are sufficient for the purpose of promoting a sound financial system. We are also
surveying auditors to enhance our understanding of the audit processes in relation to banks and to
assess the adequacy of existing audit requirements for banks.
In addition to our own assessments of these matters, we will also benefit from an external assessment
of banking supervision arrangements and other elements of financial sector regulation later this year.
That assessment will be conducted by a team of international experts led by the International
Monetary Fund, as part of the joint IMF/World Bank Financial Sector Assessment Programme - FSAP
for short. The FSAP was initiated in the aftermath of the Asian crisis, in 1999, and is designed to
evaluate a country's financial system. It includes a comprehensive assessment of regulatory
arrangements, including banking supervision and securities market regulation, using international
standards and codes as benchmarks. It also involves stress testing the financial system to assess the
system's capacity to withstand economic shocks. New Zealand will undergo an FSAP assessment
later this year, and I am sure that the assessors will take a particular interest in the banking
supervision framework and the emphasis we place on corporate governance and market disciplines.
We await the results of the FSAP assessment with considerable interest.
Although our policies are designed to strengthen the corporate governance of banks operating in New
Zealand, the foreign ownership of most of our banks introduces complications as well as advantages.
As I mentioned earlier, all but two of the registered banks in New Zealand are foreign owned,
operating in New Zealand either as branches or subsidiaries of overseas banks. This raises interesting
issues relating to corporate governance and risk management - issues to which the Bank is currently
giving further thought.
For example, in the case of banks operating as branches in New Zealand, how much reliance should
we, as the supervisor of banks, or the public more generally, place on the directors of the bank in a
foreign country for looking after the interests of creditors and other clients of the bank branch in New
Zealand? Under existing policy, foreign banks are able to operate as branches in New Zealand unless
they have substantial retail deposits or are deemed by the Reserve Bank to be systemically important.
In such cases, they must operate as locally incorporated entities. Where they do operate as branches,
we impose certain prudential requirements on them and require disclosure of the New Zealand branch
operations, but we place considerable reliance on the directors of the foreign bank to ensure that the
affairs of the bank as a whole are being prudently managed.
We recognise of course, that this approach has its limitations. In particular, we know that the directors
of a bank, and the corporate governance and risk management structures within a bank, do not
generally draw distinctions between the foreign branch of the bank and the rest of its operations. We
are also mindful that the foreign branch of a bank is legally indistinguishable from the rest of the bank,
and that assets and liabilities can move quite readily, sometimes at the push of a button, between the
branch and the rest of the bank. In fair weather, that is fine. But in times of crisis, the distinction
between the branch and the rest of the bank, and the legal location of assets and liabilities, may well
become very important indeed.
You might think that the problem associated with branch banks could easily be solved by simply
requiring banks to operate in New Zealand as locally incorporated subsidiaries. Many of the banks
currently in New Zealand do just that. But even here there are corporate governance and related
complications. Increasingly, both in New Zealand and elsewhere, international banks are managing
their affairs as a global business, regardless of whether they operate in foreign jurisdictions as
branches or subsidiaries. Core functionality, such as information technology, financial accounting and
risk management, is being increasingly managed on a global level. In some cases, this is being done
in a banking group's head office. In other cases, core functionality is being located in developing
countries to take advantage of lower cost structures. In both cases, the legal boundaries between
different parts of a banking group are becoming less relevant.
And all of that is probably just fine when things are going well. But when things do not go well - such
as in a bank failure situation - the legal divisions within a banking group and the location of core
functionality become very important indeed. And it is precisely this issue that we in the Reserve Bank
are considering at present. In a banking system where, increasingly, the core functions of banks are
being run from outside of New Zealand, we as supervisor of the banking system need to be satisfied
that there are mechanisms to ensure that the interests of New Zealanders are well served - in good
times and, especially, in bad. We are therefore currently assessing the feasibility and efficacy of
different options for ensuring that the New Zealand operations of foreign banks are structured in ways
that meet the needs of the New Zealand financial system.
Of course, this is not just an issue for the Reserve Bank. It is also an important issue for the directors
of banks in New Zealand. The directors need to be satisfied that they are fulfilling their statutory
responsibilities, and ensuring that sound corporate governance structures are in place, in the context
of a bank whose core functions are, increasingly, being performed overseas. This involves a careful
balancing act. On the one hand, directors need to ensure that the bank in New Zealand - as a
separate legal entity - is meeting, and will continue to meet, its statutory and financial obligations, and
is soundly managed and structured. On the other hand, they will inevitably and appropriately make
those kinds of assessments in the context of the bank being part of a global banking group. The
critical issue for the directors - and for the Reserve Bank - is just how much reliance should be
properly placed on the parent bank and other components of the banking group when assessing the
adequacy of the governance arrangements and prudential and operational soundness of the bank in
New Zealand.
For example, when the directors of the New Zealand subsidiary of a foreign bank form a view on the
adequacy of that bank's risk profile and management systems, how much reliance should they place
on the support of the parent entity? When assessing whether the bank is adequately capitalised, how
much weight should be placed on parent support? When core functionality is being moved out of the
bank to other parts of the group - including IT, financial accounting, and, importantly, intellectual
capital - how far should local directors go in requiring arm's length service contracts for those services,
and adequate back-up arrangements in the event of parent bank failure? When assessing the nature
of the local bank's exposures to other parts of the group, how far should directors go in ensuring that
the exposures are in the interests of the local bank? And, in all of these matters, and many more, what
is the particular role of independent directors, how many should there be on the board, and how can
one be assured that they are truly independent in their thinking and their approach to their job?
These are issues that increasingly occupy our minds in the Reserve Bank. And we are considering the
possible policy solutions to them. Increasingly, these kinds of questions will also be posed and
answered by supervisors - and by bank directors themselves - in many countries, as banks become
more global in nature. I expect that, within the next year or two, we will have made substantial
progress in seeking to resolve some of these issues.