Financial Sector Governance: The Role of the Private Sector

Michael Pomerleano

Financial Sector Development Dept.

The World BankJune 4, 2003

Strengthening Financial Sector Governance in Emerging Markets Overview by V. Sundararajan and Michael Pomerleano

http://www.worldbank.org/wbi/banking/finsecpolicy/pillars/

A clinical approach to each specialized industry in the financial sector

Banks and in particular State Banks…blurred distinction between private and public FS

Asset-Management Companies …blurred distinction between private and public FS

Public Pension Fund Management …blurred distinction between private and public FS

Mutual Funds / Collective Investment Vehicles Capital markets: Effective measures in capital

markets to exert governance over corporates

Why does corporate governance in banks warrant special attention?

Banks are funded by depositors & their failure may have systemic impact

Operating in an increasingly competitive, volatile global environment

Facing major strategic crossroads (e.g., new technology, consolidation, globalization, deregulation)

Cases during the Asian financial crisis of boards of directors under-performing

Bank Governance: The Basle Guidelines Issued in 1999

Intended complement The OECD’s Corporate Governance Principles

Focused on the unique issues related to corporate governance of banks and set out the key elements of corporate governance in banks

Objectives: To encourage practices which can strengthen corporate

governance under diverse structures -e.g. as regards the relative role of the board of directors & management. Document does not promote a particular governance structure (e.g., Anglo-Saxon vs. German models)

To assist supervisors in promoting the adoption of sound corporate governance practices by banking organizations in their countries

The Basle Guidelines

1: Strategic objectives & corporate values should be established

2: Clear lines of responsibility & accountability should be set & enforced

3: Board members should be qualified, understand clearly their role & not be subject to undue influence from management or outside concerns

4: There should be appropriate oversight by senior management

5: Work conducted by internal & external auditors should be effectively utilized

6: Compensation approaches should be consistent with the bank’s ethical values, objectives, strategy & control environment

7: Corporate governance should be conducted in a transparent manner

Issues in State Banking

Corporate Governance of Banks: Concepts and International Observations(Jerry Caprio and Ross Levine)

The situation. More than 40% of the world’s population live in countries in which most bank assets are held by state-owned banks

What are the implications? Government ownership thwarts competitive forces, limits effectiveness of government supervision; banking market suffers from opacity, need to improve accounting, auditing, credit information

Illustrative solutions Contestability of markets lessens reliance on family or

conglomerate relationships Incentives matter: legal and bankruptcy frameworks

Issues in State Banking (Cont.)

Corporate Governance of Banks: Concepts and International Observations (Jerry Caprio and Ross Levine)

Select countries solutions: U.S. has published a book with guidelines for the Board of Directors (The

OCC guide for bank directors). Thailand, Oman, and East Africa reported that they have recently released guides.

Education/ training for corporate directors re their obligations by a local institute of corporate directors. Switzerland reported that there is a local institute of corporate directors that offers training. Thailand, Philippines and Fiji advised that they recently established local institutes of directors

HKMA issued a guideline on corporate governance in locally incorporated authorized institutions in May 2000. HKMA recommendation 5 : The board of each bank should establish an audit committee with written terms of reference specifying its authorities and duties; the audit committee should be made up of non-executive directors, the majority of whom should be independent

MAS requires banks to separate financial and non-financial businesses; to change their audit firms every five years

Asset-Management Companies

THE GOVERNANCE OF ASSET MANAGEMENT COMPANIES: SELECTED OBSERVATIONS (David C. Cooke, Managing Director, Barents Group, KPMG)

The situation. Following the East Asia crisis, IBRA in Indonesia controlled 70% of financial sector

assets in Indonesia. Similarly Danaharta in Malaysia, Kamco in Korea. Often mission statement has conflicting objectives: restore financial stability,

minimize taxpayer losses, etc. Governance of AMCs impacts pace of problem resolution; responsibilities poorly

defined; oversight committees not sufficiently separated from management. Solutions: Provide for independent and informed oversight committee to articulate

policy objectives, review performance. Areas of Oversight authority typically include approval of: Operating policies,

Budget and funding proposals, Operating board members, Outside auditor, may also include approval of significant NPL transactions.

Provide an independent operating board with authority to manage AMC activities Transparent reporting Encourage stakeholders participation in corporate governance

Public Pension Fund Management and Governance (Governance Issues In Public Pension Fund Management Gregorio Impavido)

The situation. 81% of world labor force covered by partially funded or PAYG public schemes; Pension spending can reach 15% of GDP; Implicit pension debt up to 200% of GDP (Transition economies); Publicly managed pension reserves up to 55% of GDP (Malaysia).

In numerous countries multiple objectives; governance structure is murky, and performance of PPFM is poor

What are the implications? Identify good governance practices and distill into governance guidelines aimed at reducing the political influence risks that are associated with central, public pension fund management.

Public Pension Fund Management and Governance (Cont.)(Governance Issues In Public Pension Fund Management Gregorio Impavido)

Solutions: Only one objective: portfolio investing and maximizing returns

for retirees. Development of a satisfactory set of governance guidelines

tailored to public pension funds • Governors independent and fit and proper; Governors'

responsibility defined by fiduciary law; accountable for fund performance (e.g.,- Ireland, Canada)

• Independent performance evaluations should be conducted by external and independent entities on a regular basis.

• Internal controls should be established to avoid conflict of interests.

Mutual Funds

(Mark St. Giles and Sally Buxton, Cadogan Financial)

The situation. In the US investment fund assets represent 50% of GDP, whereas in

Europe 25%. In the transitional economies funds have been used for privatization. Collective investment schemes can become increasingly important financial institutions in developed countries

Types of CIS governance structures Corporate style mutual funds are found mostly in the U.S. and a few

emerging markets, and dominate in terms of value of assets. Directors have a fiduciary responsibility to look after the interests of investors.

75% of collective investment schemes by number are held in the trust or the contractual form, and are found mostly in developing countries.

The trust: made by trust deed between a management company and a trustee.The trustee has the fiduciary responsibility

The contractual fund: where investors contract with the management company. Protected by a combination of contract law, regulation and the actions of the depositary, which plays a quasi trustee role.

Mutual Funds II

No evidence that any one fund legal structure provides improved fund governance

Tentative solutions. Ability to exit a fund creates competitive commercial pressure

Transparency is critical to leveling the playing field, pressure funds to perform

Regulation for fair competition

But…. probably Better governance structure when fund management is

separate from oversight with independent corporate directors Regulation and enforcement are needed

How Effective are Capital Markets in Exerting Governance on CorporatesLessons of Recent Experience with Private and Public, Legal Rules Cally Jordan, The World Bank and Mike Lubrano, IFC

Pressures of Capital Markets will Improve Governance of Corporates and Improvements in Corporate Governance will Promote Development of Capital Markets. How?

Changes designed to facilitate better governance are not a "silver bullet" . Solutions are inextricably linked to a constellation of legal practices, institutions, and corporate governance structures.

“Legal Families” Matter “…legal families appear to shape legal rules, which in turn influence financial markets” (La Porta, et al)

Hostile takeovers are a strong disciplinary force in U.S. markets. They relied on a rather well developed high-yield bond market, that was been a source of funding for acquiring firms. However takeovers are not prevalent in emerging markets.

Importance of private rules for governance. Adopted ex ante by contract, often underpinned by voluntary codes of conduct, or through ex post enforcement through contractual dispute resolution, including arbitration, or through market discipline.

Next Steps

The program is a a start… We do not have readily available answers Considerable work is needed to develop specific

measures geared to the individual industries… while recognizing the unique circumstances of developing countries.

Ideally, a follow up collaborative research effort of the WB/IMF/Brookings

Financial Sector Governance Assessments?