A country strategy on how to improve upon corporate governance: from form to substance

Sebastian MolineusPractice Manager, Capital Markets PracticeThe World Bank

Presented on May 14, 2012, in Chisinau, Moldova

Objective and outline

To provide inputs on how to improve upon corporate governance practices in Moldova

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ObjectiveObjective

OutlineOutline 1. Defining what good corporate governance is and why it matters

2. What are the lessons from over 10 years of World Bank experience

3. A potential roadmap for Moldova

Introduction: what is and why does corporate governance matter?

Lessons learned: Corporate governance challenges across the world

A potential roadmap for reforms

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To begin with, it is important that we are all on the same page as to what good corporate governance means

The OECD defines corporate governance as:

A system by which companies are directed and controlled …

which involves a set of relationships between:

• a company’s management

• board of directors

• its shareholders and

• other stakeholders

… and which provides the structure through which company objectives are set, attained and monitored.

Simplified definition

Source: OECD Principles of Corporate Governance

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What is “bank governance”? How is it different?

Source: Basel Committee on Banking Supervision - Enhancing corporate governance for banking organisations

1. Set corporate objectives

2. Operate the bank on a day-to-day basis

3. Meet their accountability to shareholders and interests of stakeholders

4. Operate the bank in a safe and sound manner, and in compliance with laws and regulations

5. Protect the interests of depositors

The manner in which banks are governed by

their boards and senior mgmt, which affects how they:

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The following illustration offers a ‘look & feel’ of the key themes corporate governance touches upon

Robust legal & regulatoryenvironment

Strong enforcement regime

Illustration

vv

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But what does it mean to in practice?

A change in behavior!

… in the end, corporate governance is about what people in privileged or responsible positions actually do (or don’t do) with other people’s (e.g. shareholders’ and depositors’) money!

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Improves Access to Outside CapitalImproves Access to Outside Capital

Improves Valuation and Lowers the Cost of CapitalImproves Valuation and Lowers the Cost of Capital

Builds/Improves the Company’s ReputationBuilds/Improves the Company’s Reputation

Optimizes Operational and Financial EfficiencyOptimizes Operational and Financial Efficiency

• Streamlines business processes, leading to better operating performance & lower capital expenditures Gompers, Ishii and Metrick, Corporate Governance and Equity Prices, August 2001

• Improves the company’s ROCE, with firms in the top cg quartile avg. 33% & in bottom quartile 15% Credit Lyonnais SA, 2001

• Better share price performance, higher profitability, larger dividend payouts & lower risk levels than peers Lawrence Brown, Georgia State University, Sept. 2003

•Over 10 years, well-governed companies across a wide range of sectors have seen superior valuation multiples of more than 8% over their badly governed peers.

Metrick, Ishi and Gompers, Corporate Governance and Equity Prices, August 2001•One standard-deviation improvement in governance brings an improvement in valuation multiples that ranges from 18% for companies in major OECD markets to 33% in emerging markets.

Clapper and Love, World Bank, 2002

•Global Institutional Investors managing more than 1 trillion of assets state that they will pay a premium for well governed companies. Premiums avg. 30% in Eastern Europe & Africa and 22% in Asia and Latin America

McKinsey Global Investor Opinion Survey on Corporate Governance, 2002

• CG can make/break reputations by creating confidence &goodwill and building/restoring investor trust

The good news: research and practice demonstrates that good corporate governance adds to the corporate “bottom line”

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And also brings benefits to the public

For regulators and supervisors• A first line of prudential defense• Increased financial stability & reduction to

crisis

For markets• Higher market capitalization and liquidity• Increase in investor confidence and trust• Ability to attract, allocate & monitor

investment

For economies More “champion” companies that can

compete and grow internationally Higher economic growth

Introduction: what is and why does corporate governance matter?

Lessons learned: Corporate governance challenges across the world

A potential roadmap for reforms

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The World Bank has carried out 90 governance assessments or reviews in 70+ countries, including the ECA region, with the following set of lessons learned

The World Bank’s Corporate Governance Group carries-out country-level corporate governance ROSC assessments, and reviews for SOEs and financial institutionsThe World Bank’s Corporate Governance Group carries-out country-level corporate governance ROSC assessments, and reviews for SOEs and financial institutions

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1. Most boards are not fulfilling their role: that of providing managerial oversight and strategic guidance on behalf of all shareholders

RoleRole

StructureStructure

CompositionComposition

RemunerationRemuneration

Training & evaluationTraining & evaluation

• Boards involved in day-to-day management; no succession plans• Duties (of loyalty and care) defined, but not understood

• In practice, most companies have not formed board committees• Position of CEO and chairman legally separated, yet insiders

continue to dominate board

• MCGC calls on 1/3 of boards to be independent, but definition fails to cover directors who are shareholders

• In practice, few directors thought to be truly independent

• Except for the largest companies, NEDs receive low pay• Executive pay not based on formal evaluation or LT incentives

• Cultural stigma against training• Board self evaluations virtually non-existent

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Financial and non-financial disclosure in particular remains weak, despite the adoption of IFRS and ISA

IFRS typically mandatory, but often incomplete, or based on outdated versions

In practice, critical gaps in financial reporting in terms of quality and timeliness

Few companies prepare and disclose annual reports; most do not have CG sections

Little information on CG, ownership, board information, remuneration, risk structures, etc

Conflicts of interest due to the provision of non-audit workQuality of peer review process questioned

Financial institutions have often established the requisite control functions, although most remain nascent and under-resourced

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Key control functions

Risk management Risk management

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Internal controls Internal controls22

Internal audit Internal audit33

Compliance Compliance44

Key issues

Most boards do not set risk appetite, approve credits

Risks are identified, assessed, monitored in units–but not across the bank through a CRO

Risk function has sufficient authority/stature, but lacks independence, resources and board access

IC in some banks is underdeveloped due to lack underlying IT infrastructure

Inadequate follow-up to management letter

IA formally reports to CEO and AC, but in practice, strong liaison to CEO in most banks (sets salary, promotion, hiring/firing)

Few IA plans truly risk based IA function has sufficient authority/stature, but

lacks independence, resources and board access

Formal report to board but CEO typically presents for the head of compliance; position lacks authority and resources

Often consists of only one individual (0.2 vs. 1%)

“Shareholder boards” are focused on growth, dividends, and market share, but not on the bank’s risk/return dimension

“Shareholder boards” are focused on growth, dividends, and market share, but not on the bank’s risk/return dimension

Controls are under-

resourced and under-staffed

Controls are under-

resourced and under-staffed

Introduction: what is and why does corporate governance matter?

Lessons learned: Corporate governance challenges across the world

A potential roadmap for reforms

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Much has already been achieved these past ten years! However, the CG ROSC shows that a number of important challenges remain

Legal & regulatory

reforms

Legal & regulatory

reforms

Enforcement capacity

Enforcement capacity

Actual practices

Actual practices

• CG Codes/Regs launched for listed companies, banks, SOEs

• Key laws in place & recently amended; new reforms launched

• A&A, CG ROSCs commissioned

• SECs typically in place; resourced

• MoUs between the CB, SEC, MoF to ensure for financial market stability

• Launch of CG reform

• Launch of CG Centers and training programs to build capacity among directors

• To close remaining gaps in the legal and regulatory framework

• Modernize and build ‘smart’ CG frameworks

• Build enforcement capacity/ regulatory “bite”, with real fines

• Independence of regulators should be strengthened

• Boards need to fulfill their primary role of oversight/guidance

• Disclosure must be improved

• Nascent internal control frameworks are built

Today’s AchievementsToday’s Achievements Tomorrow’s ChallengesTomorrow’s Challenges

Policy Recommendations. The Government of Moldova might consider the following strategy:

1. Targeted changes to the regulatory framework Amend corporate governance code; specific regulations

2. Launch CG course for shareholders, board members and sr. managers Targeted training courses for board members and sr. managers, as well as for

technical control bodies (Internal Audit, Risk Management, etc.)

3. Incorporate CG into supervisory process CG incorporated into supervisory process and supervisors to receive targeted

training; issue implementation guide

4. Require financial institutions and other public interest entities to carry-out corporate governance (self) assessments Financial institutions to develop action and implementation plans

Develop a strategy to improve upon the corporate governance of SOEs.

5. Carry-out comprehensive review of the legal and regulatory framework, incl. Company and Banking Law

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Short term(<1 year)Short term(<1 year)

Medium term(years 2-3)Medium term(years 2-3)

Long term(>4 years)Long term(>4 years)

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But in the end …

… it is up to the private sector to demonstrate its commitment to real reforms!

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More specifically, in building a corporate governance framework, Moldovan financial institutions will need to…

Direct = to organize, energize, and supervise; to lead

In practice, this means that board need to:

Set policies and the overall direction, and not manage (“nose in, hands out”)

Guide and supervise management; set performance objectives

Act in the interest of the company and all shareholders, not a particular shareholder

Build robust corporate, board, and risk governance frameworks

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1. Create a professional, vigilant, and independent board

1. Create a professional, vigilant, and independent board

To disclose = revealing, uncovering, making known to others

2. Improve disclosure practice!

In practice, disclosure means:

Disclosing accurate, relevant and timely financial information

Disclosing non-financial information!

Being transparent to shareholders, debt-holders, depositors, regulators, and other stakeholders

Demonstrate how “other people’s money” is being used, what risks are being taken, and what returns shareholders may expect

To control = to check, test, or verify

In practice, building a robust control framework means :

Understanding the company’s risks

Implementing internal controls

Establishing an independent internal audit function

Working with (not against) the external auditor

Establishing an audit committee to coordinate the control environment

4. To create a robust control environment.

4. To create a robust control environment.

To protect = to shield from injury or damage, save from financial loss

In practice, protecting shareholder rights is to:

Inform minority shareholders of their rights

Allow all shareholders to participate in the profits of the company

Protect shareholders from abusive actions, e.g. related party transactions

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4. Protect shareholder rights4. Protect shareholder rights