Corporate Governance in the Banking Sector

“Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment.”

An oft quoted definition that so simplistically yet eloquently conveys the basic notion of corporate governance; a definition which becomes especially relevant in the context of governance of banking institutions. Corporate governance norms for the banking and financial sector has come into focus following the global economic meltdown triggered by the collapse of the world’s leading financial giants. The collapse of Lehman Brothers, JP Morgan etc only helped bring this debate into the forefront of popular imagination. Taking this forward, this paper looks at corporate governance in the banking sector, evaluates the present state of this debate and also examines whether banks need to be looked at in isolation is relation to the question of governance. It is worth mentioning here, that the present paper will restrict its enquiry to banking institutions only and will not extend it to other financial institutions.

Corporate governance can broadly be viewed as protection of investors’ interests and a sound risk management system. As mentioned above, one of the most commonly accepted definition of corporate governance, stemming from the agency concept defines it with reference to how the equity and debt holders (the principals) can influence managers of a firm (agents) to act in the best interests of those who provided capital; and the efficiency with which the manager of a firm will allocates the resources at disposal depends to the extent to which the shareholders and creditors motivate (or rather pressurizes) them. The core of the agency theory, which, lies in the separation of ownership and control, is typically viewed from a contractual platform that was initially conceived by Coase, and subsequently by Jensen & Meckling.

A promoter of a firm raises funds from investors that can either be put into productive use or to cash out his holding, in the firm. In order to generate respectable return, the promoters (financiers) need the mangers’ specialized human capital that can generate returns while on the other hand, the manager requires the financier’s funds that can be put to more effective uses; but this does not give surety of the fact, that once he puts his funds he gets back only worth the expected returns.

It has been argued by Berle and Means that diffused shareholders have the capacity to influence corporate governance through voting rights and the election of the boards of directors while the diffused debt holders can put constraints on managerial discretion through bond covenants. However, it is also common knowledge that the small investors do not enjoy exercising corporate governance primarily due to information asymmetries and poorly developed legal and regulatory mechanisms. In contrast, large investors, primarily the large equity holders and large banks are better equipped to ensure transparency and accountability in governance. Concentrated shareholders can be a corporate governance mechanism to avoid the conflict of interests between owners and managers; large equity-holders have the incentives to acquire information and monitor managers and they are able to avoid the managerial control of the board of directors.

Given this fact, corporate governance in banks and other financial intermediaries becomes very crucial, not only for the strength of their size but also their role in structuring capital allocation both at the factory level and firm level.

The Special Position Of Banks

The importance of corporate governance for banks has been studied in detail by Capario and Levine. It starts with identifying two distinctive features, opaqueness and regulation, which pose hindrance to effective corporate governance in banking institutions.

Opacity: It is argued that the greater opacity in banking makes it very difficult for diffuse debt and equity holders to monitor bank managers and also makes it harder for debt holders to control banks from risk shifting. While the controlling owners have the incentive to increase the bank’s risk profile, the debt holders on the other side, do not benefit from any upside potential from risk taking but are affected adversely if the bank goes bankrupt. Moreover, the opacity of banks makes it more difficult to design contracts that align the interests of managers and shareholders and makes it easier for insiders to exploit outside investors.

The asset quality (loan) is not readily observable and can be hidden for extensive periods, and furthermore the problems faced by such institutions can be concealed by extending further loans to clients that are unable to service the previous debt obligations. These increased informational asymmetries between insiders and outsiders in banking make it even more difficult for diffused equity and debt holders to keep a vigil on bank managers.

Before proceeding further though it ought to be mentioned that many scholars have voiced doubts about how well the opacity of banks is empirically supported. Polo identifies three papers Morgan, Iannotta, Flannery, Kwan and Nimalendran, with divergent opinions on the opacity of banks and the effect of government intervention on it. Polo observes from the above that if a unique conclusion must be drawn, it could be said that there is scope for government intervention to improve governance in banking by reducing bank opacity.

Regulation: Levine analyses the adverse implications of government regulation for the corporate governance of banks. Most countries (including India) restrict the concentration of bank ownership and the ability of outsiders to purchase a substantial percentage of bank stock without regulatory approval. The restrictions often stem out of fear pertaining to concentration of power in the economy or about the people controlling the bank.

Deposit insurance schemes reduce the incentives of depositors to monitor banks; and this along with the rise of central banks as lender of last resort, enhances incentives for bank owners or managers to increase risk necessitating governmental regulation. Government intervention, however fails when governments own banks the government is removed as an independent monitor.

The major argument usually taken in support of regulation of banks is that banks are considered to be important drivers of economic development and bank failures have a significant negative externality on the economy. The opacity in banks and the consequent information asymmetry, limited application of investor protection laws and the loop holes in the legal system to have a robust corporate governance mechanism in place make for strong arguments in favour of governmental regulation. Through governmental policies, information asymmetries can be addressed and thus transaction costs could be reduced.

Regulation primarily seeks to address systemic risks and ensure depositor protection. Central banks and their role as the lender of last resort (the Reserve Bank of India in the Indian context) and deposit insurance schemes are the main governmental instruments at preventing the systemic risks. These instruments, commonly identified as safety net, might lead to a bank moral hazard, as it diminishes depositors’ incentive to monitor banks and it increases banks’ incentive to take more risks. Moral hazard comes up when gains accrue to decision-makers while losses are borne by other agents in a heads a win, tails you lose scenario.

In this instance moral hazard arises out of equity-holder/manager versus bondholder conflicts; it is a form of agency problem wherein the bond holders provide the capital but do not control asset risks. It also stems from the de facto too-big-to-fail policies and mispriced deposit insurance: bank equity holders have greater incentives to increase asset risk and thus expropriate bondholders (here the costs are born by taxpayers and the deposits insurer). Moral hazard justifies capital regulation, whether as requiring a minimum capital as a percentage of risk adjusted assets or monitoring or supervising banks’ operations etc.

On the flip side though, many experts opine that the government lacks the will or the intention to overcome information asymmetry and reduce transaction costs. It is often believed that even for government owned banks the same are owned and used for the government’s vested interests. Governments are often seen to tax banks to add to the fiscal revenue or induce banks to lend to the influential or political people. It is also argued that the government instead of exerting a helping hand to ease market failures, use forceful means to satisfy political objectives. Similar opinions are held by many including Becker and Stigler.

Work done on the regulations of the of the private sector suggests that regulation in banks should focus more on enhancing the ability and incentives of private agents in order to over come informational barriers and induce corporate governance over banks; empirical evidence suggests that regulations, on empowering the private sector banks work best to enhance the governance in banks. While empowering direct official supervision of banks and strengthening capital standards does not seem to boost bank development or improve bank efficiency, reduce corruption in lending, or lower banking system fragility, evidence suggests that bank supervisory and regulatory policies that facilitate private sector monitoring of banks, for example forcing banks to disclose accurate information to the public, improve bank operations, bank efficiency and reduce corruption in lending.

Governance In Public Sector Banks

Coming to the aspect of the government owned banks, it becomes extremely difficult to manage a proper corporate governance framework. As far as the regulators enforcing the governance is concerned, government is virtually effectively not allowed to act as a monitor in case of such state owned banks. The government combines in itself the role of owner, regulator and sovereign. Where the government acts as both the owner as well as the regulator, the issue of conflicts of interest persists.

Jalan states, that the crucial issue that India as a country has to debate is whether corporate governance is compatible with public ownership, which makes the system accountable to political institutions and not to the economic institutions or even regulators; or whether there could be a via media wherein there could be public ownership without government or political control or whether there need to be a change in the corporate structure so that it is possible to make the boards responsible for appointment of CEOs, and make the board appointments less discretionary on the part of the Government in power. Jalan, however does not give any conclusive views on the matter and the debate as of today is still broadly open. He however suggests the need for better internal checks and balances, better auditing, better transparency, better enforcement of policies, better action over non performing assets and timely action against frauds in the interim.

Reddy notes, that government, as an owner, is accountable to political institutions in terms of broader socio-economic objectives and hence, its goals may not necessarily be compatible with purely economic incentives. He further goes on to state that mixed ownership, with the government as a major shareholder, brings into sharper focus the possible divergent objectives of share-ownership in a bank and issues relating to the rights of minority shareholders; the problem he feels gets more complex when public ownership is exercised through separate legislation and not under the company law, normally applicable to other competing entities.

Looking at the Indian context, historically the legal as well as policy framework has always emphasized co-ordination in the interest of national development as per the 5-year plan priorities with the result, the issue of corporate governance became subsumed in the overall development framework. To that extent each bank, even after nationalisation, maintained its distinct identity, and the governance structure as incorporated in the concerned legislations provided for a formal structure of relationship between the Reserve Bank, government, board of directors and management. The role of the Reserve Bank as a regulator became essentially one of being an extended arm of the government so far as highest priority was accorded to ensuring coordinated actions in regard to activities particularly of public sector banks.

An Advisory Group on Corporate Governance, under the Chairmanship of Dr. R. H. Patil, which had submitted its report in 2001 made detailed assessment and gave recommendations on corporate governance mechanisms of Indian banks to bring them on par with international practices had also focused on public sector banks. It had recommended that, all the banks are brought under a single Act so that the corporate governance regimes do not have to be different just because the entities are covered under multiple Acts of the Parliament or that their ownership is in the private or public sector. Noting that merely diluting the government holding in public sector banks will not make a significant difference, it pointed to the inequality among the various board members of the public sector banks with the nominees of the Reserve Bank and Government are treated to be superior to other directors. It recommended that parity should be brought on this front and that constitution of the board be reformed. As regards the role of the Reserve Bank, it was recommended that in its roles as the regulator the RBI does not need to have representation on the bank boards, given the fact that it leads to conflicts of interests with its regulatory functions. Further, any policy measures to protect banks that are less careful in their lending policies at the cost of tax payers’ money need to be tempered in such a way that they do not encourage profligate lending by banks. These are among the more significant recommendations as regards public sector banks.

In 2001, a Consultative Group of Directors of Banks and Financial Institutions under the Chairmanship of Dr. A.S. Ganguly was constituted to review the supervisory role of boards of banks and financial institutions and to obtain feedback on the functioning of the boards vis-à-vis compliance, transparency, disclosures, audit committees etc. and make recommendations for making the role of board of directors more effective. The group made its recommendations very after a comprehensive review of the existing framework as well as of current practices and benchmarked its recommendations with international best practices as enunciated by the Basel Committee on Banking Supervision, as well as of other committees and advisory bodies, to the extent applicable in the Indian environment. It recommended inter alia, the exercise of due diligence in the appointment of directors of all banks, public or private sector in regard to their suitability for the post by way of qualifications and technical expertise; the Government, it was recommended while nominating directors on the Boards of public sector banks should be guided by certain broad “fit and proper” norms for the Directors. The office of the Chairman and Managing Director was recommended to be separated in respect of large sized public sector banks. This functional separation, it was felt will bring about more focus on strategy and vision as also the needed thrust in the operational functioning of the top management of the bank.

Reddy in numerous occasions have emphasized on the importance of corporate governance in public sector banks, not only because they happen to dominate the banking industry, but also because, they are unlikely to exit from banking business though they may get transformed. To the extent there is public ownership of such banks, the multiple objectives of the government as owner and the complex principal-agent relationships cannot be ignored. And they cannot be expected to blindly mimic private corporate banks in governance though general principles are equally valid. Furthermore, the expectations, the reputational risks and the implied even if not exercised authority in respect of the part-ownership of Government in the governance of such banks should be recognised.

He further identifies, as the most important challenge faced in enhancing corporate governance and in respect of which there has been significant though partial success relates to redefining the interrelationships between institutions within the broadly defined public sector i.e., government, the Reserve Bank and public sector banks to move away from “joint family” approach originally designed for a model of planned development. As part of reform the government he feels has to differentiate, conceptually and at the policy level, its role as sovereign, owner of banks and overarching supervisor of regulators including the Reserve Bank. The central bank he feels has to (and has already done so to some extent) move away from sharing the nitty gritty of developmental schemes with government involving micro regulation, to a more equitable treatment of all banks as regulator and supervisor. The large publicly owned non-financial enterprises Reddy argued need to recognize the need for a more commercial and competitive approach with banks including public sector banks in raising of and deployment of funds and for achieving this he advocates a narrowing of gap between public sector banks and other banks in terms of the policy, regulatory and operating environment.

Conclusion

In summation, in this paper, an effort has been made to analyse the position of banks as regards corporate governance. It has been seen that owing to the opacity of banks and the relatively high degree of regulation, corporate governance measures are often faced with a hinderance. While this is generally true for all banking institutions, the governance issues become more difficult in government owned banks or public sector banks because the government typically owns, manages and regulates such banks. An attempt has been made, so provide a snapshot of the suggestions made to overcome the obstacles in this regard and to that extent suggestions made by stalwarts in the Reddy and Patel have been analysed. However as mentioned above this debate is in no way a concluded one and the issue still remains to quote from Reddy, “is public ownership compatible with sound corporate governance as generally understood?”

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