INTERNATIONAL CORPORATE GOVERNANCE

2012

INTERNATIONAL CORPORATE GOVERNANCE

CORPORATE GOVERNANCE PRACTICES OF INDIAN BANKS

HIMANSHU VERMA-S116780 ANKIT DOKANIA-S116300 PULKIT KHARE-S116390

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ABSTRACT In banking parlance, the Corporate Governance refers to conducting the affairs of a banking organisation in a manner that gives a fair deal to all the stake holders i.e. shareholders, bank customers, regulatory authority, employees and society at large. Poor corporate governance of banks has increasingly been acknowledged as an important cause of the recent financial crisis. In India, even though we largely escaped the financial crisis, banking industry in India needs to introspect on its own shortcomings and loose practices. Further, we need to analyse was it the strong regulatory environment or the strong accountability, transparency and ethics that made Indian banks tide over the crisis. In India, banking industry is largely dominated by the public sector. This means they are not only competing with themselves but also other major private players in the banking system as well as in financial services system. These may include Financial Institutions, Mutual Funds and other intermediaries, in a new environment of liberalization and globalization. Also, the penetration level of banking sector in India is very less when compared to the fast paced development India has witnessed in recent years, which makes their role even more important. Further, with restrictive support available from the Govt. for further capitalization of banks, many banks may have to go for public issues, leading to transformation of ownership. Also, with FDI norms for private sector banks being liberalized, corporate governance practices assumes immense importance from the purview of foreign investors. The role of banks is to mobilize and allocate societys savings. Especially in developing countries like India, banks can be very important source of external financing for firms. Also, banks exert corporate governance over firms, especially small firms that have no direct access to financial markets. Banks corporate governance gets reflected in corporate

governance of firms they lend to. Thus, our aim will be to analyze corporate governance practices of Indian banks from above viewpoints.
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OBJECTIVE
Through this paper we seek to understand the: a) Corporate Governance of the banking industry in general b) How banks are different from the business organizations c) Analyze the Indian Banking Industry with respect to the Corporate Governance framework

Corporate Governance of Banks: Its Genesis and As to Why is it Important?

Corporate governance refers to the set of systems, principles and processes by which a company is governed. They provide the guidelines as to how the company can be directed or controlled such that it can fulfil its goals and objectives in a manner that adds to the value of the company and is also beneficial for all stakeholders in the long term. Stakeholders in this case would include everyone ranging from the board of directors, management, shareholders to customers, employees and society. The management of the company hence assumes the role of a trustee for all the others. An important theme of discussions concerning corporate governance is the nature and extent of accountability of decision makers inside the corporation, and mechanisms that try to decrease the principal agent problem. The failure of high profile companies such as Enron, WorldCom and Parmalat is a clear lesson of the damage poor corporate governance can inflict. The seeds of modern corporate governance were probably sown by the Watergate scandal in the USA. Subsequent investigations by US regulatory and legislative bodies highlighted regulatory failures that had allowed several major corporations to make illegal political contributions and bribe government officials. While these developments in the US stimulated debate in the UK, a spate of scandals and collapses in that country in the late 1980s and early 1990s led shareholders and banks to worry about their investments. Several companies in UK which saw explosive growth in earnings in the 80s ended the decade in a

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memorably disastrous manner. Importantly, such spectacular corporate failures arose primarily out of poorly managed business practices. This debate was driven partly by the subsequent enquiries into corporate governance (most notably the Cadbury Report) and partly by extensive changes in corporate structure. In May 1991, the London Stock Exchange set up a Committee under the chairmanship of Sir Arian Cadbury to help raise the standards of corporate governance and the level of confidence in financial reporting and auditing by setting out clearly what it sees as the respective responsibilities of those involved and what it believes is expected of them. The Committee investigated accountability of the Board of Directors to shareholders and to the society. It submitted its report and the associated code of best practices in December 1992 wherein it spelt out the methods of governance needed to achieve a balance between the essential powers of the Board of Directors and their proper accountability. Being a pioneering report on corporate governance, it would perhaps be in order to make a brief reference to its recommendations which are in the nature of guidelines relating to, among other things, the Board of Directors and Reporting & Control. The Cadbury Report stipulated that the Board of Directors should meet regularly, retain full and effective control over the company and monitor the executive management. There should be a clearly accepted division of responsibilities at the head of the company which will ensure balance of power and authority so that no individual has unfettered powers of decision. The Board should have a formal schedule of matters specifically reserved to it for decisions to ensure that the direction and control of the company is firmly in its hands. There should also be an agreed procedure for Directors in the furtherance of their duties to take independent professional advice. The Cadbury Report generated a lot of interest in India. The issue of corporate governance was studied in depth and dealt with by the Confederation of Indian Industries (CII), Associated Chamber of Commerce and Industry (ASSOCHAM) and Securities and Exchange Board of India (SEBI). These studies reinforced the Cadbury Reports focus on the crucial role of the Board and the need for it to observe a Code of Best Practices.

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How Banks are different from other Businesses

Good Corporate Governance Practises of banks is different from other corporates in important respects, and that makes corporate governance of banks not only different but also critical. A sound banking system forms the backbone of a sound economy and a healthy economy. Sound Corporate Governance practises are of utmost importance especially for emerging market economies because

Banks have an overwhelmingly dominant position for an economys financial systems, and are extremely important engines of economic growth.

As financial markets are usually underdeveloped, banks in developing economies are typically the most important source of finance for the majority of firms.

Banks in developing countries are usually the main depository for the economys savings.

Fourth, many developing economies have recently liberalised their banking systems through privatisation/disinvestments and have reduced the role of economic regulation. Consequently, managers of banks in these economies have obtained greater freedom in how they run their banks.

Bank assets are unusually opaque, and lack transparency as well as liquidity. This condition arises due to the fact that most bank loans, unlike other products and services are usually customised and privately negotiated.

There is contagion effect resulting from the instability of one bank, which would affect a class of banks or even the entire financial system and the economy. For example the downfall of the famous U.S Investment Bank, Lehman Brothers, brought the entire world economy on the brink of recession and added fuel to the 2008 US recession.

Given the centrality of banks to modern financial systems and the macro economy, the larger ones become systemically important. That raises a moral hazard issue since systemically important banks will then indulge in excessive risk in the full knowledge that all the gains will be theirs; and should the risks blow up, the

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government or the central bank will bail them out and thereby the losses can be socialized. Having collectively experienced the biggest financial crisis of our generation over the last three years, we all know that these risks and vulnerabilities of the financial system are all highly probable real world eventualities.

INDIAN BANKING INDUSTRY

The Indian Banking industry, which is governed by the Banking Regulation Act of India, 1949 can be broadly classified into two major categories, non-scheduled banks and scheduled banks. The apex decision making body in the Indian Banking is the Reserve Bank of India. Scheduled banks comprise the commercial banks and the co-operative banks. In terms of ownership, commercial banks can be further grouped into nationalized banks, the State Bank of India and its group banks, regional rural banks and private sector banks (the old/ new domestic and foreign). These banks have over 67,000 branches spread across the country. Further details about the structure of Indian Banking industry can be found in Annexure-1. The first phase of financial reforms began in India in 1969 when 14 major banks were nationalized and resulted in a shift from Class banking to Mass banking. This in turn resulted in a significant growth in the geographical coverage of banks. Every bank had to earmark a minimum percentage of their loan portfolio to sectors identified as priority sectors. The manufacturing sector also grew during the 1970s in protected environs and the banking sector was a critical source. The next wave of reforms saw the nationalization of 6 more commercial banks in 1980.

After the second phase of financial sector reforms and economic liberalization of the sector in 1991, the Public Sector Banks (PSB) found it extremely difficult to compete with the new private sector banks and the foreign banks. The new private sector banks first made their appearance after the guidelines permitting them were issued in January 1993. Eight new private sector banks are presently in operation. These banks due to their late start have access to state-of-the-art technology, which in turn helps them to save on manpower costs and provide better services.
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Reserve Bank of India has ensured that the transparency and accounting standards in India have been enhanced to align with international best practices. It has followed a three pronged strategy: Off-site surveillance - monitoring the movement of assets, its impact on capital adequacy and overall efficiency and adequacy of managerial practices in bank. Peer Group Comparison Brings out the periodic date on critical ratios to maintain peer pressure for better performance and governance. Prompt corrective action policy Trigger points as capital adequacy ratio, NonPerforming Assets (NPA) and Return on Assets (ROA) as proxies for asset quality and profitability.

Corporate Governance Importance in Indian Context

Sound corporate governance becomes all the more important in the Indian context for the following reasons: A lot of new multinational banks are coming to India in the backdrop of the opportunities presented by the growth of the economy. There is a general tendency by the MNCs to exploit the loopholes in the system if the corporate governance laws are not stringent. Percentage of shareholding by government is 68%-70% in public sector banks, so due to this high ownership, sometimes agency problems may arise (Annexure-1) With the increased needs for capital and limited help from the government has led many banks to go for public issue, which has led to change in ownership. With FDI norms for private banks being liberalised, corporate governance practices has assumed immense importance from the purview of foreign investors. There has been a spur in the investment activities in India, due to which there has been a steep rise in the need for capital by Indian firms.The lending pattern by the banks is a reflection of the corporate governance prevalent. The penetration of the banking system in the rural areas where the majority of India lives is still very low. Micro financing Institutions, NBFC (Non Banking Financial

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Corporations) and Cooperative Banks have been instrumental in bridging the growing demand for capital and its supply. These banks have come under a lot of flak lately because of their lack of transparency and hence special corporate governance practises need to be formulated for these kinds of institutions.

Evolution of Corporate Governance of Banks in India

The initiative to initiate corporate governance of Indian banks dates back to 2001, when in March, an advisory group on Corporate Governance examined the state of corporate governance in Indian banks. The group under chairmanship of Dr. R.H.Patil made recommendations to bring the corporate governance practices in line with the best global practices. The first formal policy initiative with respect to corporate governance of banks in India was made by Dr. Bimal Jalan in the mid-term review of Monetary and credit policy in October, 2001. Further, a Consultative group was formed under Dr. A. S. Ganguly to strengthen the internal supervisory role of the boards. Now, as we have seen, the level of opaqueness and the relatively greater role of government and central bank in their functioning set the banking sector apart from other businesses. This is to this effect that Reserve Bank of India started the process to strengthen the corporate governance in Indian banking sector. The current regulatory framework ensures that there is uniform treatment meted out to public and private banks in terms of prudential norms. Prudential regulations are regulations of deposit-taking institutions like banks and supervision of the conduct of these institutions and set down requirements that limit their risk-taking. These requirements can be in the form of maintaining a stipulated Tier I Capital or a minimum Capital Adequacy Ratio etc. This market orientation of governance disciplining in banking has been accompanied by a stronger disclosure norms and stress on periodic RBI surveillance. From 1994, the Board for Financial Supervision (BFS) inspects and monitors banks using the CAMELS (Capital adequacy, Asset quality, Management, Earnings, Liquidity and Systems and controls) approach. Audit committees in banks have been stipulated since 1995. Greater independence of public sector banks has also been a key feature of the reforms. Nominee directors from government as well as RBIs are being gradually phased off with
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a stress on Boards being more often elected than appointed from above. There is increasing emphasis on greater professional representation on bank boards with the expectation that the boards will have the authority and competence to properly manage the banks within the broad prudential norms set by RBI. Rules like non-lending to companies who have one or more of a banks directors on their boards are being softened or removed altogether, thus allowing for related party transactions for banks. The need for professional advice in the election of executive directors is increasingly realized. In the pre-reform era, there were very few regulatory guidelines governing corporate governance of banks. This was reflective of the dominance of public sector banks and relatively few private banks. That scenario changed after the reforms in 1991 when public sector banks saw a dilution of government shareholding and a larger number of private sector banks came on the scene. The competition brought in by the entry of new private sector banks and their growing market share forced banks across board to pay greater attention to customer service. As customers were now able to vote with their feet, the quality of customer service became an important variable in protecting, and the increasing, market share. Post-reform, banking regulation shifted from being prescriptive to being prudential. This implied a shift in balance away from regulation and towards corporate governance. Banks now had greater freedom and flexibility to draw up their own business plans and implementation strategies consistent with their comparative advantage. The boards of banks had to assume the primary responsibility for overseeing this. This required directors to be more knowledgeable and aware and also exercise informed judgement on the various strategy and policy choices. Two reform measures pertaining to public sector banks Entry of institutional and retail shareholders and Listing on stock exchanges

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-brought about marked changes in their corporate governance standards. Directors representing private shareholders brought new perspectives to board deliberations, and the interests of private shareholders began to have an impact on strategic decisions. On top of this, the listing requirements of SEBI enhanced the standards of disclosure and transparency. To enable them to face the growing competition, public sector banks were accorded larger autonomy. They could now decide on virtually the entire gamut of human resources issues, and subject to prevailing regulation, were free to undertake acquisition of businesses, close or merge unviable branches, open overseas offices, set up subsidiaries, take up new lines of business or exit existing ones, all without any need for prior approval from the Government. All this meant that greater autonomy to the boards of public sector banks came with bigger responsibility. A series of structural reforms raised the profile and importance of corporate governance in banks. The structural reform measures included mandating a higher proportion of independent directors on the boards; inducting board members with diverse sets of skills and expertise; and setting up of board committees for key functions like risk management, compensation, investor grievances redressal and nomination of directors. Structural reforms were furthered by the implementation of the Ganguly Committee recommendations relating to the role and responsibilities of the boards of directors, training facilities for directors, and most importantly, application of fit and proper norms for directors.

Basel Norms and their relation to Corporate Governance

Basel committee is a committee of banking supervisory authorities, established by the Central Bank Governors of the G10 developed countries in 1975. The Committee in 1988 introduced the Concept of Capital Adequacy framework, known as Basel Capital Accord. As per Basel committee Report 1999, Banks have to display the exemplary of corporate governance practices in their financial performance, transparency in the balance sheets and compliance with other norms laid down by section 49 of corporate governance rules.
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Basel II uses a "three pillars" concept (1) Minimum Capital Requirements (addressing risk) - deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk, and market risk. (2) Supervisory review - Supervisory review process has been introduced to ensure not only that banks have adequate capital to support all the risks, but also to encourage them to develop and use better risk management techniques in monitoring and managing their risks. (3) Market discipline - Market discipline imposes strong incentives to banks to conduct their business in a safe, sound and effective manner. It is proposed to be effected through a series of disclosure requirements on capital, risk exposure etc. so that market participants can assess a banks capital adequacy. Basel II proposals, especially the second and third pillars, underscore the interaction between sound risk management practices and corporate good governance. The Basel Committees document, Principles for enhancing corporate governance, sets out best practices for banking organisations. The practices are: The board has overall responsibility for the bank, including approving and overseeing the implementation of the overall risk strategy, banks policies for risk management, compliance and banks strategic objectives, internal control system, compensation system etc. The boards qualifications, in terms of adequate knowledge and experience, relevant to each of the material financial activities the bank intends to pursue to enable effective governance and oversight of the bank The banks need to have an effective internal control systems and a risk management function to identify, monitor and manage risks on an ongoing firm-wide and individual entity basis

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The banks need to have an independent risk management function, including a chief risk officer or equivalent with sufficient authority, stature, independence, resources and access to the board

The board should actively oversee the compensation systems design and operation, and should monitor and review the careful alignment of employee compensation with prudent risk-taking

The governance of the bank should be adequately transparent to its shareholders, depositors, other relevant stakeholders and market participants. The banks disclosure should include, but not be limited to: o Material information on the banks objectives, o Organisational and governance structures and policies, o Major share ownership and voting rights and related parties transactions o Incentive and compensation policy

The Indian Banks have been complying with the Basel II requirements of pillar 2 & 3 from 2009 and 2010 respectively. Implementation of Basel II norms for pillar 1 has been taken up in a sequential and progressive manner with the final implementation of advanced approaches by 2014.

Important parameters relating to Corporate Governance in India

Bank Ownership Interest of shareholders Vs Interest of Depositors-Conflict is between profits and safety of deposits. Depositors and bank customers have little say in the governance of the banks, while shareholders especially the promoters in case of private banks hold an important say in the governance of the banks. Frequent agency problems can arise. Public Vs. Private ownership- Issue arises because in India most of the banks are in public sector.
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Accountability, Transparency and Ethics

Over the years measures have been taken to make boards more accountable to all stakeholders and ensure transparency in their functioning. The separation of ownership and management can create conflict of interest if there is a breach of trust by managers on account of intention, omission, negligence or incompetence as we have seen on global stage. But, we need to analyse using examples from different Indian banks as to whether the voice of independent directors always independent? Do bank CEOs countenance criticism from the board? It is only through such soul searching that corporate governance of banks can improve its effectiveness. The failure on the scale we saw during the recent global financial crisis is also reflective of poor ethical standards in banks. The behaviour of actors across the chain of the financial sector was swayed by the opportunity for making quick profit rather than by fair, ethical and moral standards. Neither were the sub-prime borrowers adequately warned that there was a good chance of fall in asset prices nor did investment advisers tell their clients of the risk they were taking in buying MBAs and CDOs. Such behaviour was not only checked, but was even encouraged.

Compensation
Executive compensation for banking officials worldwide has two main components, salary based and performance based commission. The performance based compensation is given to the banking officials based on the basis of the profits made by the company in that fiscal year. This generally leads to a tendency where the banking CEOs get myopic and take unnecessary risks with the aim of booking only short term profits, and have total disregards for the long term profits and welfare of the company. This has been attributed as one the main reasons of the 2008 US recession which led to a financial turmoil worldwide. The US Banking officials got short sighted and kept on lending to less credible borrowers, and the Investment Bankers kept buying the risky CDOs and CMOs, as they were drawing heavy compensation for the business being generated by them. This fuelled the entire housing bubble, and when the bubble burst, it lead to the collapse of a lot of banks and the
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entire financial system. A cue of the same can be taken from the line and bar graph, shown in Annexure 1 (cash flow). There was a sharp rise in the Wall Street bonuses in the early and mid 2000 period when sub prime lending was at its peak that is just before the financial crises. After the 2008 financial crisis the executive compensation of Banking officials has come under a lot of flak from different quarters and steps are being taken to bring in regulations in this regard. Dodd-Frank Act is one of the acts passed in this regard. In March, 2011 SEC moved forward a proposal requiring at least 50 percent of annual incentive compensation for executive officers of large financial firms to be deferred for no less than three years. In an attempt to realign bankers bonuses with long term performance, the FDIC became the first agency to implement the Dodd Frank requirement prohibiting financial institutions from offering any compensation arrangements that could lead to material financial losses for the company. Under the FDIC proposal, now supported by the SEC, the deferred portion of annual incentive compensation can be paid no faster than on a pro-rata basis (i.e 1/3 per year for three years). One of the main reasons that India did not feel the heat of the 2008 crisis like the other nations is because of the sound Corporate Governance laws in the Banking sector. The central bank of India, RBI derives its power to intervene on issues such as compensation of bank CEOs from the Banking Regulation Act. In fact, the act empowers the RBI to even issue directions to banks to fix salaries at a certain levels. It regulates the compensation packages of the CEOs of the banking officials, in line with the principles of the Financial Stability Board (FSB) and Basel committee. According to the Banking Regulations Act, the RBI of India has the power to regulate board compensation, including the pays and perquisites of the CEOs of private sector banks. In evaluating compensation proposals for whole time directors and CEOs of private banks, the Reserve bank is guided by relevant factors such as performance of the bank, compensation structures in the peer group, industry practice and regulatory concerns. As regards to bonuses, in terms of the Reserve Bank guidelines issued in August 2003, bonus in respect of whole time directors and CEOs has been capped at 25 per cent of their salary or at the level of Bonus paid to other employees of the bank. Though
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the RBI does not have clear guidelines or parameters on CEO compensation in banks, it is said to be guided by the size of the banks. Multinational banks, though under RBIs regulatory framework, escape such strictures. In India, according to a banker in a top private bank, the CEO salaries can be broadly categorized thus as follows: Rs. 1 crore for public sector banks (Approx. $200,000 USD); Rs. 2.5-3 crores ($500,000 USD-$600,000 USD) for private sector banks and Rs 8-9 crores ($ 1,800,000 USD-2,000,000 USD) for foreign banks.

Governance and performance in Microfinance Institutions

Governance is about achieving corporate goals. For the MFI, multiple goals exist. The fundamental goal is to contribute to development. This involves reaching more clients and poorer population strata, the so-called main outreach 'frontier' of microfinance. A second goal is to do this in a way that achieves financial sustainability, preferably independence from donors. There has to be separation of responsibilities of promoter/chairperson/CEO as chairperson cannot play this role effectively if the same person is also running the daily operations as CEO/MD. This defeats the very purpose of corporate governance. Committees should be created which utilizes a well-defined board and addresses key issues. There should be well-defined and clearly drafted procedures are essential for effective governance.

Policy on MFIs and enabling environment

Now in India, there is an urgent need of a well-accepted Microfinance policy supported by regulatory and supervisory framework, which is still missing at the cost of the stakeholders. Finally, the importance placed on microfinance as a development instrument, combined with the increasing inflow of capital/funds to the industry, indicates a need to better understand governance systems for MFIs. In recent times, there have been three cases that are important while studying corporate governance in India because they signify a change in corporate governance practices in
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India. The cabinet approving the Companies Bill; Successor to Mr Ratan Tata being announced; and Mr Akula had exiting SKS Microfinance Limited, a company founded by him. The Bill has several corporate governance and disclosure norms. The new Companies Act will be contemporary and will improve corporate governance practices, if implemented effectively. Succession planning is an important issue in corporate governance. Investors suffer when the board of directors fails in its responsibility to identify the successor well in time. This was demonstrated by naming the new successor of the TATA Group after Mr. Ratan Tata. And, finally the exit of Mr Akula from SKS Micro finance Limited, the only listed micro finance company, provides some lessons in corporate governance. The first is that holding of majority voting rights by institutions does not necessarily improve corporate governance. The companys shareholding pattern as at September 2011 was: Promoters: 37%, FII 19%, Indian Financial Institutions: 6%, Indian Bodies Corporate: 14%, Foreign Bodies Corporate: 12 % and others: 12%. Effective corporate governance requires institutions to play their role effectively. That has not happened in the case of SKS. Second is that the corporate governance system comes under stress when a company deviates from its stated vision and mission. The last learning from the SKS episode is that the Board should intervene immediately when it senses rift in the management. It cannot take the approach of wait and watch. Such an approach delays the intervention and causes huge damage to the company. The board has to take harsh decisions well in time before the damage is done. I believe that the three events of the previous week signals a new dawn in the Indian corporate governance.

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Annexure 1-

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Annexure (Contd.)

(Source: Reserve Bank of India)

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References
Balasubramaniam, C S; Pradhan, Rudra Prakash (Dec 2005). Corporate Governance and its Role in Banking Sector, Finance India Chakarbarti ,Rajesh;Yadav ,Pradeep K. 'Corporate Governance In India' ,Journal of Applied Corporate Finance Gopinath, Shyamala (Jul 2008). Corporate governance in the Indian banking industry, International Journal of Disclosure and Governance, suppl. Special Issue: Disclosure and Governance Policies Narayana, M Srinivasa; Sesha Mohan, V V (Nov 2007). Corporate Governance in Indian Banking Industry, Institute of Cost and Works Accountants of India Mckisney & Company (2007) Report on Indian Banking, Towards Global Best Practices Prasun Kumar Das(2011). Towards Corporate Governance of Microfinance Institutions in India. Working Paper No:SRM/KIIT/2

Websites
http://business-standard.com/india/news/3-cheers-for-corporate-governance/456851/ http://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?fromdate=08/04/05&S ecId=21&SubSecId=0 http://www.expressindia.com/latest-news/Too-high-cut-CEO-pay-RBI-tells-threeprivate-banks/470979/ www.ibef.org

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