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CORPORATE GOVERNANCE IN BANKS

1. INTRODUCTION
Corporate Governance has as its backbone a set of transparent relationship between an institutions management, its Board, shareholders and other stakeholders. It should therefore take into account a number of aspects such as enhancement of shareholders value, protection of rights of shareholders, composition and role of Board of Directors, integrity of accounting practices and disclosure norms and internal control system. As far as the banking industry is concerned, corporate governance relates to the manner in which the business and affairs of individual banks are directed and managed by their Board of Directors and Senior management. It also provides the structure through which objectives of the institution are set, the strategy of attaining those objectives is determined and the performance of the institution is monitored. The term governance has been derived from the word gubernare, which means to rule or steer. The word was originally meant to be normative framework for exercise of power and acceptance of accountability thereof in the running of kingdoms, regions and towns. However, over the years, the term has found significant relevance in the corporate world. This is particularly so in the context of the growing number and size of the corporations, the widening base of shareholders, increasing linkages with the physical environment, and their overall impact on the societys well-being. Governance has assumed greater importance with the series of corporate failings, both in the public and private sectors, following which the markets, investors and the society have begun to lose faith in the infallibility of these large systems. Nowadays, the conduct of those who take care of public money is being questioned since they are the agents of the stakeholders who have invested their money in corporations. Ultimately, corporate governance can be improved by making corporate operations more transparent, without sacrificing business strategy and secrets, which are absolutely necessary for the success in the competitive market place. More and more corporations are, therefore, being tested on minimum ethical standards laid down by the shastras and several regulatory agencies. They have to meet both, ethical and legal norms in the conduct of the company.

CORPORATE GOVERNANCE IN BANKS The last two decades of corporate literature have made a significant amount of contribution to corporate governance, which started from the Sir Adrian Cadbury Committees report and continued in the Hampel Committees report, the Kings Committees report, the Greenbury Committees report, the Combined Code of the London Stock Exchange, the OECD Code on Corporate Governance, the Blue Ribbon Committees report, the CII guidelines in India and Sebi-appointed KM Birla Committee recommendations. All this literature emanated due to identification of some specific problem areas of corporate management practices all around the world and attempts from various corners to solve these problems. The Enron debacle of 2001, involving the hand-in glove relationship between the auditor and the corporate client, the scam involving the fall of corporate giants in the US,(like WorldCom, Qwest, Global Crossing, Xerox) and the consequent enactment of the stringent SarbanesOxley Act in the US were some important factors which made the Indian Government wake up. The Naresh Chandra Committee was appointed in 2002 to examine and recommend drastic amendments to the law relating to the auditor-client relationship and the role of the independent directors. In 2002, the Securities and Exchange Board of India (Sebi) analyzed the statistics of compliance with Clause 49 of the listed companies and within a gap of few months in 2003 constituted the Narayana Murthy Committee.

1.1 CONCEPT OF CORPORATE GOVERNANCE


To conceptualize corporate governance, we need to understand both the terms governance and corporations. Governance is a set of the minimum framework of rules necessary to tackle problems guaranteed by a set of institutions. On the other hand, corporation means: A legal entity that exists independently of the person or persons who have been granted the charter creating it, and that is vested with many of the rights given to the individual. Thus, by applying the concept of governance in the corporate world, what we get is the term corporate governance. A countrys system of corporate governance comprises of formal and informal rules, along with accepted practices and enforcement mechanisms, both private and public. Taken together, these govern the relationships between the people who effectively control corporations and those who invest in them. However, the poor quality of 2

CORPORATE GOVERNANCE IN BANKS local systems of corporate governance lies at the heart of one of the greatest challenges facing most countries in the developing world. Recent corporate governance failures in the US and Europe remind us that such breakdowns can severely affect the lives of thousandsemployees, retirees, savers, creditor, customers, suppliers in countries where market economies are well developed. Corporate governance among different participants in the organization such as the board, managers, shareholders and other stakeholders, spells out the rules and procedures for making decisions on corporate affairs. Corporate governance, therefore, is concerned with the establishing a system whereby the directors are entrusted with the responsibilities and duties in relation to the directors and day-to-day operation of a companys affairs. It also founded on the system of accountability, primarily directed towards the shareholders, in addition to maximizing the shareholders welfare in the long term. An effective corporate governance system should provide mechanisms for regulating a directors duties in order to restrain them from abusing their powers and to ensure that they act in the best interest of the company in a broad sense. Corporate governance is also concerned with wider accountability and the responsibility of directors towards their stakeholders in the corporation, such as the companys employees, consumers, suppliers, creditors and the wider community. Sheridan and Kendall believe that good corporate governance consists of a system of structuring, operating and controlling a company in order to achieve the following objectives: To fulfill the long-term strategic goals of the owners which may consist of building shareholder value or establishing a dominant market share or maintaining a market lead in a chosen sphere; To consider and care for the interest of the employees(past, present and future) including planning future needs, recruitments, training and working environment, severance and retirement procedures through to looking after pensioners; To maintain good relations with customers and suppliers in matters such as quality of service, ordering mechanisms and account settlement procedures;

CORPORATE GOVERNANCE IN BANKS To take account of needs of the environment and the local community, in terms of the physical effects of the companys operation on the surrounding area, and the economic and cultural interaction with the local population; To maintain proper compliance with all the applicable legal and regulatory requirements under which the company is carrying out its activities. In 1992, the Cadbury Committee on the financial aspects of corporate governance considered the concept of corporate governance and defined it as a system by which companies are directed and controlled. The board of directors is responsible for the governance of the companies. Moreover, the shareholders role in governance is to appoint directors and auditors and satisfy themselves that an appropriate governance structure is in place. Corporate Governance has succeeded in attracting a good deal of public interest because of its importance for the economic health of corporations and the welfare of society, in general. However, the concept of corporate governance is defined in several ways because it potentially covers the entire gamut of activities having direct or indirect influence on the financial health of the corporate entities. As a result, different people have come up with different definitions, which basically reflect their special interests in the field. So I feel, the best way to define the concept is perhaps to list a few of the different definitions rather than mentioning just one or two. Before attempting to do this, it would be useful to recall the earliest definition of Corporate Governance by the Economist and Noble laureate Milton Friedman. According to him, Corporate Governance is to conduct the business in accordance with owner or shareholders desires, which generally will be to make as much money as possible, while conforming to the basic rules of the society embodied in law and local customs. This definition is based on the economic concept of market value maximization that underpins shareholder capitalism. Apparently, in the present day context, Friedmans definition is narrower in scope. Over a period of time the definition of Corporate Governance has been widened. It now encompasses the interests of not only the shareholders but also many stakeholders.

CORPORATE GOVERNANCE IN BANKS

1.2 DEFINITION:
The OECD has defined corporate governance as involving 'a set of relationships between a companys management, its board, it shareholders, and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and shareholders and should facilitate effective monitoring, thereby encouraging firms to use resources efficiently.' Corporate governance in banks assumes importance in view of the critical role of banks in any economy as financial intermediaries, repositories of vast credit-related information and as part of the payments system. The existence of sound corporate governance in banking organizations is fundamental to their own sound functioning and to the stability of the banking system as a whole. No amount of controls, systems and regulation can be a replacement for sound corporate governance. At its best, sound corporate governance in banks almost takes on a role akin to that of an efficient, well informed and detached supervisory authority thereby facilitating sound banking supervision. The BCBS has defined corporate governance, from a banking industry perspective, as involving 'the manner in which the business and affairs of individual institutions are governed by their boards of directors and senior management, affecting how banks:

Set corporate objectives (including generating economic returns to owners); Run the day-to-day operations of the business; Consider the interests of recognized stakeholders; Align corporate activities and behaviors with the expectation that banks will operate in a safe and sound manner, and in compliance with applicable laws and regulations; and

Protect the interests of depositors.'

CORPORATE GOVERNANCE IN BANKS While several basic standards put forward earlier by the BCBS had referred to corporate governance in some context or the other, a comprehensive set of standards focusing on corporate governance was set out by it in the paper on Enhancing Corporate Governance in Banking Organizations (September 1999). The paper, while reiterating the issues rose earlier, emphasizes the importance of the OECD principles for banks. The Group has tried to evaluate the current status on corporate governance in banks in India against the international standards and codes as set out in the BCBS paper. The evaluation of the Group and its suggestions on those areas where compliance is not up to the best international standards have been presented in Annex 2. The main points arising there from are discussed in the following paragraphs. Ownership and corporate governance The Group, while recognizing that banks and financial institutions are of various types, constituted under different statutory provisions, feels that the nature of a banks ownership is not a critical factor in establishing sound corporate governance practices. The quality of corporate governance should be the same in all types of banking organizations irrespective of the nature of their ownership. Thus, the sound practices for corporate governance apply in equal measure, if not more, to government owned banks also which dominate the Indian banking scene. Since the depth and extent of compliance of the standards of corporate governance may vary from bank to bank, within an overall generalized level, it is desirable that all banks meet a certain benchmark level representing an acceptable standard of corporate governance. From this level, there will have to be a sustained progress towards best international standards, the achievement of which within a reasonable timeframe will be targeted. Constitution of boards The banks need to follow the best practices in respect of constitution and functioning of the boards. It is, therefore, suggested that the process of induction of directors into banks boards and their initial orientation may be streamlined. The boards of banks do not seem to subject themselves to any measure of accountability or performance either set by them

CORPORATE GOVERNANCE IN BANKS voluntarily or made applicable to them externally. This leaves them, largely, without any accountability either to the institution itself or to the supervisor. This situation calls for correction. Though selection for nomination of individuals on banks boards is on the basis of his/her qualification considered suitable for the position, there is no practice of pre-induction meeting/briefing or any post-induction orientation. As such, often a proper appreciation of their role in banks corporate governance takes time to develop. A system of pre-induction meetings as well as post-induction orientation for the newly appointed directors on the boards of banks needs to be introduced. Boards and accountability Good governance requires that boards establish strategic objectives and a set of corporate values that are communicated throughout the organization. The boards do often not define these very clearly and their communication throughout the organization is quite uneven. Long-term problems and hindrances in the way of achieving organizational goals tend to receive attention only at higher levels of management. Banks need to develop mechanisms, which can help them ensure percolation of their strategic objectives and corporate values throughout the organization. Boards need to set and enforce clear lines of responsibility and accountability for themselves as well as the senior management and throughout the organization. However, boards of directors in very few banks are known to enforce clear lines of responsibility and accountability for themselves. In quite a few cases, there is not enough clarity about their roles. Much of this is because of the manner in which the boards are constituted. There is an urgent need to follow the internationally acknowledged best practices in banks in respect of constitution and functioning of boards. Members of Board of Directors are required to give their valuable time to the governance of banks. In this context, there is a need to have a definite ceiling on the number of boards and the number of Committees a director can work in at a time.

CORPORATE GOVERNANCE IN BANKS Committees of the board The boards of banks are required to form Committees for risk management, audit, compensation, nomination, etc. The Audit Committees in banks are quite well established in discharging their functions. Introduction of systems for risk management in Indian banks is however rather recent and so are the risk management committees of the board. While it would be practicable for big banks to put in place independent and effective risk management systems and processes, smaller banks lack the expertise in this area and, therefore, will have to be given special attention by way of encouragement as well as technical support so that they can imbibe risk management practices in as short a time as possible. A timeframe of two to three years is considered adequate for the purpose. Save in a few small private sector banks, remuneration of employees is not linked to their performance. In the public sector banks, which account for more than 80 per cent of the countrys banking sector, remuneration has so far been fixed at the industry level with the approval of the Government of India. In such a situation, there is hardly any room for linkage between individual performance and remuneration. For understandable reasons, therefore, public sector banks do not have a remuneration committee of the board. There is a need to review the current practice and link remuneration with performance. It is desirable that performance measurement, currently confined mostly to operating units, e.g., branches, is extended to individuals and a linkage between performance and remuneration/reward is established. It should be possible to do so even in the public sector banks if a consensus can be achieved between the unions and the management on converting the present flat and unrelated to performance remuneration structure prevalent in most banks into a performance-related remuneration structure. There is an urgent need to review the current practice and link performance with remuneration. Compensation Committees could be set up under the new arrangement. Nomination Committees are expected to assess the effectiveness of the board and direct the process of renewing and replacing board members. As of now, there are no such committees except in the case of some private sector banks. There is also no established system to assess

CORPORATE GOVERNANCE IN BANKS the effectiveness of the functioning of the board members. Such Committees and assessments would be desirable. The present system of nomination of directors on the boards of banks is neither appropriate nor effective in the entirely changed environment and is, therefore, expendable. Nomination Committees of the boards should be formed and allowed to function freely. Transparency and corporate governance The current standards of transparency would need to be raised. A fair beginning has been made in this regard but the approach of the banks and the applicable accounting standards will have to be changed for achieving greater transparency in banking operations and accounting. Public disclosure is desirable in the areas of structure of the board and senior management, basic organizational structure, incentive structure and the nature and extent of transactions with affiliated and related parties. Though the structure of the board is normally revealed in the balance sheets of banks, details of committees of the board, and the qualifications of the directors are not always available publicly. Disclosures in respect of this and the other aspects mentioned above need to be encouraged. Transactions with affiliated and related parties are not disclosed in the balance sheets of banks. All such information should be available in the public domain. Further, though Section 20 of the Banking Regulation Act, 1949, prohibits loans and advances to directors and their connected parties, there is no statutory restriction on dealings with large shareholders. A provision on the lines of Section 20 of the Banking Regulation Act, 1949, on connected lending will have to be made in respect of large shareholders and a clear definition of large shareholding would need to be provided.

Role of supervisor and government Because of Reserve Bank of India/Government ownership of banks (in the public sector), there is some overlap in the role of the Reserve Bank of India as owner/owners representative and as the regulator/supervisor. This overlap needs to be corrected so that

CORPORATE GOVERNANCE IN BANKS Reserve Bank of India can perform its regulatory/supervisory role without any hindrance/conflict of interest. Government ownership of banks is not conducive to any serious and urgent corrective action by the regulator against any one of them. The limitations of the legal process have also come in the way even where corrective action like removal of management not found to be 'fit and proper' was contemplated.

Some other definitions: Let us take a look at the other definitions in the context of the present day situation. 1. According to some experts "Corporate Governance means doing everything better, to improve relations between companies and their shareholders; to improve the quality of outside Directors; to encourage people to think long-term; to ensure that information needs of all stakeholders are met and to ensure that executive management is monitored properly in the interest of shareholders." 2. Experts of the OECD have defined Corporate governance as the system by which business corporations are directed and controlled. According to them the corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the Board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it provides the structure through which the company objectives are set, and also provides the means of attaining those objectives and monitoring performance. OECD's definition, I feel, is consistent with the one presented by Cadbury Committee. 3. An article published in the June 21, 1999 issue of the Financial Times quoted J. Wolfensohn, President, World Bank as saying that "Corporate Governance is about promoting corporate fairness, transparency and accountability" And 10

CORPORATE GOVERNANCE IN BANKS 4. According to some economists, Corporate Governance is a field in economics that investigates how corporations can be made more efficient by the use of institutional structures such as contracts, organizational designs and legislation. This is often limited to the question of shareholder value i.e. how the corporate owners can motivate and/or secure that the corporate managers will deliver a competitive rate of return. These are just a few definitions of Corporate Governance. However it may be of interest to know the genesis of the subject (Corporate Governance) and in this context I would like to briefly share with you the historical perspective.

1.3 HISTORICAL PERSPECTIVE


The seeds of modern Corporate Governance were probably sown by the Watergate scandal in the United States. As a result of subsequent investigations, US regulatory and legislative bodies were able to highlight control failures that had allowed several major corporations to make illegal political contributions and to bribe government officials. This led to the development of the Foreign and Corrupt Practices Act of 1977 in USA that contained specific provisions regarding the establishment, maintenance and review of systems of internal control. This was followed in 1979 by the Securities and Exchange Commission of USAs proposals for mandatory reporting on internal financial controls. In 1985, following a series of high profile business failures in the USA, the most notable one of which being the Savings and Loan collapse, the Treadway Commission was formed. Its primary role was to identify the main causes of misrepresentation in financial reports and to recommend ways of reducing incidence thereof. The Treadway report published in 1987 highlighted the need for a proper control environment, independent audit committees and an objective Internal Audit function. It called for published reports on the effectiveness of internal control. It also requested the

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CORPORATE GOVERNANCE IN BANKS sponsoring organizations to develop an integrated set of internal control criteria to enable companies to improve their controls. Accordingly COSO (Committee of Sponsoring Organizations) was born. The report produced by it in 1992 stipulated a control framework which has been endorsed and refined in the four subsequent UK reports: Cadbury, Rutteman, Hampel and Turnbull. While developments in the United States stimulated debate in the UK, a spate of scandals and collapses in that country in the late 1980s and early 1990's led shareholders and banks to worry about their investments. These also led the Government in UK to recognize that the then existing legislation and self-regulation were not working. Companies such as Polly Peck, British & Commonwealth, BCCI, and Robert Maxwells Mirror Group News International in UK were all victims of the boom-to-bust decade of the 1980s. Several companies, which saw explosive growth in earnings, ended the decade in a memorably disastrous manner. Such spectacular corporate failures arose primarily out of poorly managed business practices. It was in an attempt to prevent the recurrence of such business failures that the Cadbury Committee, under the chairmanship of Sir Adrian Cadbury, was set up by the London Stock Exchange in May 1991. The committee, consisting of representatives drawn from the top levels of British industry, was given the task of drafting a code of practices to assist corporations in U.K. in defining and applying internal controls to limit their exposure to financial loss, from whatever cause.

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2.CADBURY COMMITTEE REPORT


The stated objective of the Cadbury Committee was "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 associated "Code of Best Practices" in Dec 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. The resulting report, and associated "Code of Best Practices," published in December 1992, was generally well received. Whilst the recommendations themselves were not mandatory, the companies listed on the London Stock Exchange were required to clearly state in their accounts whether or not the code had been followed. The companies who did not comply were required to explain the reasons for that. The Cadbury Code of Best Practices had 19 recommendations. Being a pioneering report on Corporate Governance, it would be in order to make a brief reference to them. The recommendations are in the nature of guidelines relating to the Board of Directors, Nonexecutive Directors, Executive Directors and those on Reporting & Control.

Relating to the Board of Directors these are:

The Board 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 a company, which will ensure balance of power and authority, such that no individual has unfettered powers of decision. In companies where the Chairman is also the

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CORPORATE GOVERNANCE IN BANKS Chief Executive, it is essential that there should be a strong and independent element on the Board, with a recognized senior member.

The Board should include non-executive Directors of sufficient caliber and number for their views to carry significant weight in the Boards decisions. 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 be an agreed procedure for Directors in the furtherance of their duties to take independent professional advice if necessary, at the companys expense. All Directors should have access to the advice and services of the Company Secretary, who is responsible to the Board for ensuring that Board procedures are followed and that applicable rules and regulations are complied with. Any question of the removal of Company Secretary should be a matter for the Board as a whole.

Relating to the Non-executive Directors the recommendations are :

Non-executive Directors should bring an independent judgement to bear on issues of strategy, performance, resources, including key appointments, and standards of conduct.

The majority should be independent of the management and free from any business or other relationship, which could materially interfere with the exercise of their independent judgement, apart from their fees and shareholding. Their fees should reflect the time, which they commit to the company.

Non-executive Directors should be appointed for specified terms and reappointment should not be automatic. Non-executive Directors should be selected through a formal process and both, this process and their appointment, should be a matter for the Board as a whole.

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For the Executive Directors the recommendations in the Cadbury Code of Best Practices are:

Directors service contracts should not exceed three years without shareholders approval. There should be full and clear disclosure of their total emoluments and those of the Chairman and the highest-paid UK Directors, including pension contributions and stock options. Separate figures should be given for salary and performance-related elements and the basis on which performance is measured should be explained.

Executive Directors pay should be subject to the recommendations of a Remuneration Committee made up wholly or mainly of Non-Executive Directors.

And on Reporting and Controls the Cadbury Code of Best Practices stipulate that:

It is the Boards duty to present a balanced and understandable assessment of the companys position. The Board should ensure that an objective and professional relationship is maintained with the Auditors. The Board should establish an Audit Committee of at least 3 Non-Executive Directors with written terms of reference, which deal clearly with its authority and duties.

The Directors should explain their responsibility for preparing the accounts next to a statement by the Auditors about their reporting responsibilities. The Directors should report on the effectiveness of the companys system of internal control. The Directors should report that the business is a going concern, with supporting assumptions or qualifications as necessary.

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3. BASEL COMMITTEE PUBLICATION ON CORPORATE

GOVERNANCE FOR BANKING ORGANISATIONS.


Basel Committee published a paper on Corporate Governance for banking organisations in Sep 99. Let me share with you some of the issues and concerns shared in that Paper. The Committee feels it is the responsibility of the banking supervisors to ensure that there is effective corporate governance in the banking industry. Supervisory experience underscores the need of having appropriate accountability and checks and balances within each bank to ensure sound corporate governance, which in turn would lead to effective and more meaningful supervision. Sound corporate governance could also contribute to a collaborative working relationship between bank managements and bank supervisors. Basel Committee underscores the need for banks to set strategies for their operations. The committee also insists banks to establish accountability for executing these strategies. Unless there is transparency of information related to decisions and actions it would be difficult for stakeholders to make management accountable.. From the perspective of banking industry, corporate governance also includes in its ambit the manner in which their boards of directors govern the business and affairs of individual institutions and their functional relationship with senior management. This is determined by how banks :

Set corporate objectives (including generating economic returns to owners); Run the day-to-day operations of the business and; Consider the interests of recognised stakeholders i.e. employees, customers, suppliers, supervisors, governments and the community and Align corporate activities and behaviours with the expectation that banks will operate in a safe and sound manner, and in compliance with applicable laws and regulations; and protect the interests of depositors.

You may be aware that the Committee has issued several papers on specific topics, where the importance of corporate governance is emphasised. These include Principles for the

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CORPORATE GOVERNANCE IN BANKS management of interest rate risk (September 1997), Framework for internal control systems in banking organisations (September 1998), Enhancing bank transparency (September 1998), and Principles for the management of credit risk (issued as a consultative document in July 1999). These papers have highlighted the fact that sound corporate governance should have, as its basis, the following strategies and techniques:

The corporate values, codes of conduct and other standards of appropriate behaviour and the system used to ensure compliance with them; A well-articulated corporate strategy against which the success of the overall enterprise and the contribution of individuals can be measured; The clear assignment of responsibilities and decision-making authorities, incorporating an hierarchy of required approvals from individuals to the board of directors;

Establishment of a mechanism for the interaction and cooperation among the board of directors, senior management and the auditors; Strong internal control systems, including internal and external audit functions, risk management functions independent of business lines, and other checks and balances; Special monitoring of risk exposures where conflicts of interest are likely to be particularly great, including business relationships with borrowers affiliated with the bank, large shareholders, senior management, or key decision-makers within the firm (e.g. traders);

The financial and managerial incentives to act in an appropriate manner offered to senior management, business line management and employees in the form of compensation, promotion and other recognition; and

Appropriate information flows internally and to the public.

For ensuring good corporate governance, the importance of overseeing the various aspects of the corporate functioning needs to be properly understood, appreciated and implemented. There are four important forms of oversight that should be included in the organizational structure of any bank in order to ensure the appropriate checks and balances: (1) oversight by the board of directors or supervisory board; (2) oversight by individuals not involved in

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CORPORATE GOVERNANCE IN BANKS the day-to-day running of the various business areas; (3) direct line supervision of different business areas; and (4) independent risk management and audit functions. In addition to these, it is important that the key personnel are fit and proper for their jobs.

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4. CORPORATE GOVERNANCE AND SEBI GUIDELINES


It is too premature to reach conclusions on the objectivity of the corporate governance in its mandatory form that is now being given a fair trial by SEBI. Certainly, guidelines issued by SEBI made corporate governance a reality in our companies; they are well intentioned. Seemingly, the guidelines spared no effort in restructuring our corporate managementsparticularly the corporate boards. The endeavors are directed to ensure that corporate boards comprised not only of generalists but also multi displinary groups-all applicable of judgment and decision on current performance as well as future plans in companies. The revamp that emerged is seen as the key feature of the guidelines, where by independent Non- Executive Directors (INEDs), unconnected with promoter groups, are assigned a greater role. INEDs should now be at least 50% of the Board and 100% of audit committee for all companies with paid up capital and free reserves of Rs. 10 cr and turnover of Rs 50 cr and above. INEDs are also expected to be financially literate. The objective seems to be to empower INEDs to such an extent not hitherto seen in our corporate bodies. In the same way, the reconstructed Audit Committees(Acs), where the chairman and every member is a INED, are allowed a more vibrant role. It is also made obligatory for the chairman of Audit Committee to be present at the Annual General Meeting (AGM) of the company. The SEBI guidelines, in no unambiguous terms, made INDEs and Acs an integral part of our corporate boards with the intent to simultaneously improve the diligence, ethics and transparency required for raising the set disclosure standards. The guidelines do carry with them a mandatory odour, being a part of section 49 of listing agreements, which may perhaps be a reason for the unsavory criticism heard at times in some quarters. But it does not take away the credit due to the authorities and corporates, who, at every stage strived hard to arrive at consensus on the form and content of the guidelines, before they are mandated. Contribution made by committees headed by corporate lenders like Kumara Mangalam Birla and N.S. Narayana Murthy to enhance the adaptability of the guidelines is particularly noteworthy.

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5. MAJOR RECOMMENDATIONS
The Group's recommendations are fairly detailed and do not lend themselves easily to condensation. However, the major recommendations, which, in the opinion of the Group, needs to be highlighted are listed below: 5.1 Core Principles i. ii. Powers to RBI to decide on capital requirements on a case by case basis needs to be clearly defined in law. A stricter review of the proposed arrangements and standards for internal control as well as the managements philosophy and business objectives at the pre-licensing stage of banks will greatly mitigate possible hazards during the operational stagesRBI should apply stricter norms for the fit and proper test while evaluating directors and the quality of the board. iii. While fixing the definition of 'substantial interest' at a higher level, it would be desirable to require banks to obtain the prior approval of the supervisor for any proposed changes in ownership or exercise of voting rights over the threshold. Forbearance in taking measures against banks that fail to meet minimum capital adequacy ratios cannot be long term and specific measures against such banks need to be stipulated in the interest of the overall soundness of the system. (Paragraph 2.4.1) iv. v. RBI should also gradually move towards setting bank specific capital ratios based on their individual risk profiles RBI may assist and guide banks in their efforts to stabilise advanced risk management systems. Larger and more capable banks may be encouraged to complete the process early so that they can act as leaders and models for the smaller and not so well equipped banks. A system for classification of offbalance sheet items on the lines of the extant system of classification of funded exposures should be put in place and a note to that effect provided in banks financial statements. RBI may consider issuing suitable detailed

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CORPORATE GOVERNANCE IN BANKS instructions requiring banks to have mechanisms in place for continually assessing the strength of guarantees and appraising the worth of collateral. vi. 'Closely related groups' need to be explicitly defined and the supervisor should have the discretion, prescribed in law, in interpreting the definition on a case by case basisRBI may consider issuing instructions to the effect that loans to connected and related parties which are not fully collateralised may be deducted from banks capital to the extent that they are not collateralised. Banks should be instructed to monitor the total amount of loans to connected and related parties and introduce an independent credit administration process. Limits on aggregate exposures to connected and related parties by a bank need to be established vii. Advanced risk management capabilities must be in place in all banks latest by the end of the financial year 2002-2003. RBI may assist banks in hastening introduction of the more scientific and sophisticated risk management systems. viii. ix. Banks should be required to include a statement on their risk management policies and procedures in their publicly available documents. A more formal and rigorous assessment of the boards performance must be undertaken by the regulator. The regulator should adopt rating of the boards performance with the provision that, if the rating falls below a certain specified level, prompt corrective action should be triggered. x. In the context of globalisation and ever increasing domestic and cross-border flows of funds, the implementation of 'Know Your Customer' guidelines should be verified by the supervisor and adherence thereto made more stringent. xi. xii. RBI should consider moving over to a risk-based approach to supervision as early as possible. Quality of management needs to be given greater weightage in supervisory assessments.

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CORPORATE GOVERNANCE IN BANKS xiii. RBI may consider introducing meetings with banks boards and external auditors in the interest of greater involvement of the board with supervisory concerns and actions in order to enrich the scope of examination of banks. xiv. xv. RBI may consider using independent and well qualified external auditors to examine specific aspects of banks operations. The move towards consolidated accounting and supervision needs to be expedited. Steps need to be taken so that necessary legal provisions are introduced and banks are required to prepare consolidated accounts. xvi. xvii. RBI may impress upon the government the need and urgency of achieving and maintaining a high level of coordination among different regulators. The public sector character of banks remains an important consideration in the supervisor deciding upon and initiating sanctions and/or penalties on banks. RBI should consider introduction of measures by which clear accountability can be fixed on individual directors and/or the board of directors for non-performance and/or negligence of their duties. xviii. The range of possible actions available to RBI should include imposition of conservatorship which can enable a bank in difficulty to gain some time until it completes remedial measures. xix. A suitable legal provision obliging the statutory auditors of banks to report on matters of material significance to the regulators will strengthen the supervisory regime. xx. RBI should practice consolidated supervision over internationally active banking organisations of which it is the home country supervisor. RBI should endeavour to get into formal relationship with host country supervisors on the basis of MoUs. 5.2 Corporate governance i. ii. The quality of corporate governance should be the same in all types of banking organisations irrespective of their ownership. The process of induction of directors into banks boards and their initial orientation may be streamlined. 22

CORPORATE GOVERNANCE IN BANKS iii. Banks need to develop mechanisms which can help them ensure percolation of their strategic objectives and corporate values throughout the organisation.

iv.

Boards need to set and enforce clear lines of responsibility and accountability for themselves as well as the senior management and throughout the organisation.

v.

Linkage purpose.

between

contribution

and

remuneration/reward

should

be

established. Compensation Committees of the board could be set up for the vi. vii. Nomination Committees to assess the effectiveness of the board and direct the process of renewing and replacing board members are desirable. Disclosures in respect of committees of the board and qualifications of the directors, incentive structure and the nature and extent of transactions with affiliated and related parties need to be encouraged. viii. A provision on the lines of Section 20 of the Banking Regulation Act, 1949, which prohibits loans and advances to directors and their connected parties, will have to be made in respect of large shareholders also. Information on transactions with affiliated and related parties should be disclosed. ix. There is some overlap in the role of the Reserve Bank of India as owner/owners representative and as the regulator/ supervisor, which should be corrected. x. Government ownership of banks is not conducive to any serious and urgent corrective action by the regulator.

23

CORPORATE GOVERNANCE IN BANKS

6. ISSUES RELATING TO CORPORATE GOVERNANCE


i. It is recognized that independence is the cornerstone of accountability and that independent boards are essential to a sound governance structure. In India in most banks the CEO and Chairmans positions is combined. There has been much debate concerning the wisdom and feasibility of an independent chairman. The Cadbury Committee had stated that there should be a clearly accepted division of responsibilities at the head of a company which will ensure a balance of power and authority such that no one individual has unfettered powers of decision. Where the Chairman is also the Chief executive it is essential that there should be a strong and independent element on the board with a recognised senior member. The US Corporate Governance Core Principles has also addressed this issue. It states that a substantial majority of the board should consist of directors who are independent. Where the CEO also chairs the Board he is clearly more powerful than the Board. It has therefore suggested that when the chair of the board also serves as the companys CEO the board designates formally or informally an independent director who acts in a lead capacity to coordinate the other independent directors. In a discussion paper brought out by Shri S.H. Khan, Chairman, NSE and former Chairman IDBI on Corporate Governance of Financial Institutions, this issue has been raised. According to him "to avoid the concentration of power in the hands of a single individual and, in recognition of the pivotal role of the Chairman in securing good corporate governance, it is important that the roles of the Chairman and of the Chief Executive Officer be separated and different individuals appointed to the positions. The Chairman should ideally be a non-executive director of the institution." In India too we need to examine how to ensure balance of power and authority where the roles of CEO and Chairman are combined at the same time not confusing accountability or disrupting daily operations. Certain board committees should also consist entirely of independent directors. The feasibility of compensation pattern in banks in the form of cash and stock may also become relevant in future. ii. One of the principles of sound banking regulation is that "connected lending" should not be permitted i.e. lending by banks to directors or companies in which directors

24

CORPORATE GOVERNANCE IN BANKS are interested. The Banking Regulation Act does not permit such lending. A similar provision/regulation does not apply to financial institutions (FIs) and it is possible for directors on the board of FIs to continue to enjoy borrowing facilities from the FIs. This needs to be reviewed. iii. The other issue relates to the number of non-executive directors. In public sector banks we have currently two whole time directors including CEO and the rest are non-executive directors and nominee directors. Employee directors are also on the board. A suggestion has been made that the number of executive directors should be increased. The Cadbury Committee has suggested that the board should include nonexecutive directors of sufficient calibre and number for their views to carry significant weight in the boards decisions. The Khan discussion paper has recommended that independent non executive directors should constitute a majority on the board. Ordinarily, not less than two third of the total strength of the board should be non-executive directors. To ensure that they bring an independent judgment to bear on issues of strategy, performance and standards of conduct, he has suggested that a majority of the non executive directors should be independent of the institution as well as of the Government. To ensure balance in the composition of the board, it is necessary that at least three or four directors not exceeding one third of the total strength be executive directors. It will be useful to have the views on these issues from the participants. iv. Recently, the Monetary Authority of Singapore (MAS) issued a statement on measures to strengthen the banking system. One of the measures relating to corporate governance is to require all local banks to form Nominating Committees within the Boards. The Nominating Committee will comprise five members of the Board where appointments will be made by the board subject to MAS approval. The purpose of the Committee is to ensure that only the most competent individuals are appointed to the board and key management position. In India a major challenge is to professionalise Board of Directors. To conclude, the new strategy of supervision recognizes strong corporate governance function supported by competent (executive) management as the first line of defense in

25

CORPORATE GOVERNANCE IN BANKS supervision of banks and financial institutions. The Reserve Bank of India has appointed the following Working Groups in order to bring about systemic improvements in the financial sector:1. In the light of the Narasimham Committee recommendations relating to urban banks, the RBI has appointed a working group to evolve objective criteria, to determine the need and potential for organising urban cooperative banks, review the existing entry point norms and the existing policy pertaining to branch licensing and area of operation of urban cooperative banks, to consider measures for determining the future set up of weak/unlicensed banks and to examine the feasibility of introducing capital adequacy norms for urban cooperative banks and to suggest necessary legislative amendments to BR Act and Cooperative Societies Act of various states for strengthening the urban banking movement. 2. Reserve Bank of India has decided to undertake a study of the existing system of Deposit Insurance in India and of the need for certain reforms therein as a crucial component of the financial sector reforms which are being implemented. It has accordingly set up a high powered Advisory Group. It is proposed to establish a credit information bureau for the collection of credit information relating to borrowers and providing such information to the financial system with a view to facilitating better credit risk Management.

26

CORPORATE GOVERNANCE IN BANKS

7. CORPORATE PRACTICES

GOVERNANCE: TOWARDS BEST

Corporate governance is increasingly demanding our attention and has moved centrestage. The Enron and WorldCom scandals in the U.S have amply demonstrated the necessity of having a system of corporate governance even in the developed world. In a liberalising and deregulating country like India, corporate governance is all the more important. In this context, it is indeed heartening to note that Bankers conference is devoting a full session on "corporate governance". In this address let me touch upon the basic cornerstones of corporate governance in Indian banking sector.

7.1 THE BASIC ISSUE


Modern day corporations are known for the separation of ownership and control. After all, the managers are merely paid employees and the agency theory taught us that the independent managers can operate in a way that could be detrimental to the interests of the shareholder. It is, thus necessary, to have a mechanism by which the shareholders interest are protected by the managers. It is here that corporate governance can play a crucial role. What is corporate governance then? I can do no better than to quote from Professors Shleifer and Vishney, who defined corporate governance as dealing with "the ways that suppliers of finance to corporations assure themselves of getting a return on their investment". 1 Corporate governance is however conceptually different for banks. The business model of financial intermediaries especially of banks envisages dealing in the financial resources of others and most of their liabilities constitute debt which are in the form of deposits. Since depositors are the main suppliers of finance to a bank, their interest is paramount and therefore directors and officers of a bank should be charged with a heightened duty to ensure the safety and soundness of these enterprises. Banks are highly leveraged organisations, they undertake maturity transformation and hence create maturity mismatches between their assets and liabilities and rely on the confidence of their creditors. There is also the contagion impact and the issue of maintaining the integrity of the payments system in which banks play a significant role. Corporate governance therefore affects the interests of a larger cross-

27

CORPORATE GOVERNANCE IN BANKS section of stakeholders also has implications for financial stability and is one of the key factors that determines the health of the system and its ability to survive economic shocks. Corporate governance practices differ widely across the world. In a highly dispersed shareholding system normally it is the board of directors who are granted the responsibility of monitoring executives (e.g., U.S). On the other hand, allowing for concentrated and cross shareholding, countries like Germany or Japan adopted internal corporate governance systems. Corporate governance for an emerging market economy (EME) has an added dimension. After all, since the late 1980s / early 1990s, the financial sector of a number of EMEs has seen a wave of liberalisation and deregulation. Greater deregulation in markets and in banks operations requires better governance as more responsibility rests with the Board and the management. It is because banks are a critical component of the economy that it is universally a regulated industry and banks have access to safety nets. It would, however, be erroneous to conclude that regulatory oversight is a substitute to corporate governance. There exists complementarity between regulation and corporate governance in banking. Perhaps it is in this spirit that the Bank for International Settlement (BIS) in discussing enhancing corporate governance for banking organisation observed that, "banking supervision cannot function as well if sound corporate governance is not in place and consequently, banking supervisors have a strong interest in ensuring that there is effective corporate governance in every banking organisation".

7.2 GLOBAL BEST PRACTICES


A number of supranational organisations have drawn codes/principles of corporate governance. The most well known is perhaps the OECD principles of corporate governance of 1999. It is instructive to summarise the five basic pillars of OECD code, viz., (i) Protecting the rights of shareholders; (ii) Ensuring equitable treatment of all shareholders including having an effective grievance redressal system; (iii) Recognising the rights of stakeholders as established by law; (iv) Ensuring the timely and accurate disclosure regarding the corporation including the financial situation, performance, ownership and

28

CORPORATE GOVERNANCE IN BANKS governance of the company; and (v) Ensuring the strategic guidance of the company, effective monitoring arrangement by the board and the boards responsibility to the company and the shareholder. While the OECD principles went a long way in emphasising the basic tenets of corporate governance, it is the 1999 BIS paper that went specifically to the issue of enhancing corporate governance for banking organisation. From banking industry perspective, BIS proposed the following seven principles: i) Establishing strategic objectives; ii) Setting and enforcing clear lines of responsibility and accountability; iii) Ensuring that the board members are qualified for their position and are not subject to undue influence from the management or outside concerns; iv) Ensuring that there is appropriate oversight by senior management; v) Effectively utilising the work conducted by internal and external auditors; vi) Ensuring that compensation approaches are consistent with the banks ethical values; and vii) Conducting corporate governance in a transparent manner. Again, from a banking sector perspective, the BIS principles noted categorically two specific things, viz., a. The role of supervisors, and b. The paramount interest of depositors. Apart from such supranational organisations or regional organisation like EU, all the G-7 countries as well as other developed economies have codified some kind of best practices on corporate governance, or some specific aspects of it. While a comprehensive survey of the country-specific principles of corporate governance is beyond the scope of the present address, one is tempted to cite the recently enacted Sarbenes-Oxley Act of 2002 in US, 29

CORPORATE GOVERNANCE IN BANKS aiming to protect investors by improving the accuracy and reliability of corporate disclosures. It is against this background of global best practices let me now turn to the Indian experience on corporate governance.

7.3 CORPORATE GOVERNANCE AND INDIAN BANKS


The initial formal moves towards corporate governance in India can be traced in 1997 with the voluntary code framed by the Confederation of Indian Industry (CII). A number of companies over the next three years (nearly 30 large listed companies accounting for over 25 per cent of Indias market capitalisation) voluntarily adopted the CII code.
2

The next

major cornerstone in the Indian case has been the SEBI Committee chaired by Shri Kumar Mangalam Birla (1999), as the first formal and comprehensive attempt to evolve a Code of Corporate Governance, in the context of prevailing conditions of governance in Indian companies and the state of capital markets. The Committee recommended that the fundamental objective of corporate governance is the "enhancement of shareholder value , keeping in view the interests of other stakeholder". The Committee made recommendations of far-reaching implications for several issues, such as, the independence of board, accounting standards and financial reporting, share-holders rights and responsibilities, and formation of audit and remuneration committee. The initial move towards corporate governance in banks can be traced in the Advisory Group on Corporate Governance for the RBI Standing Committee on International Financial Standards and Codes, chaired by Dr. R.H. Patil, which submitted its Report in 2001. The Advisory Group has noted that the predominant form of corporate governance in India is much closer to the East Asian insider model where the promoters dominate governance in every possible way. Among the various recommendations , strengthening of the Companies Act and the role of Independent Directors deserve special mention. The Group looked into public sectors banks and noted that the first important step to improve governance mechanism in these units is to transfer the actual governance functions from the concerned administrative ministries to the boards and also strengthen them by streamlining the

30

CORPORATE GOVERNANCE IN BANKS appointment process of directors. Furthermore, as a part of strengthening the functioning of their boards, banks should appoint a risk management committee of the board in addition to the three other board committees viz., audit, remuneration and appointment committees. The Advisory Group on Banking Supervision for the Standing Committee on International Financial Standards and Codes, while looking into several areas in which internationally accepted best practices are already in place, probed into corporate governance as well. The noteworthy minimum benchmarks noted by the Group relate to the following: (i) Strategies and techniques basic to sound corporate governance; (ii) Organizational structure to ensure oversight by board of directors and individuals not involved in day-to-day running of business; (iii) Ensuring that the direct line of supervision of different business areas are different; (iv) Ensuring independent risk management and audit functions; (v) Ensuring an environment supportive of sound corporate governance; and (vi) Role of supervisors. Interestingly, with reference to public sector banks, the Group noted that the nature of a banks ownership is not a critical factor in establishing sound corporate governance practices and concluded that, "the quality of corporate governance should be the same in all types of banking organisations irrespective of the nature of their ownership". The Group, however, felt that there are some areas where practices in the Indian banking sector fell short of international best practices, viz., a) constitutions of boards, b) their accountability, and c) their involvement in risk management. The Group gave special emphasis on enhanced transparency in the constitution and structure of the board and senior management and in public disclosures. Taking this move towards corporate governance further, the Reserve Bank constituted a Consultative Group of Directors of Banks and Financial Institutions (Chairman: Dr. A.S.

31

CORPORATE GOVERNANCE IN BANKS Ganguly) to review the supervisory role of Boards of banks and FIs. The Ganguly Consultative Group looked into the functioning of the Boards vis--vis compliance, transparency, disclosures, audit committees and suggested measures for making the role of the Board of Directors more effective. The Group submitted its recommendations in April 2002. The major recommendations of the Group are the following: i) Government while nominating directors on the Boards of PSBs should be guided by certain broad "fit and proper" norms for the Directors, based on the lines of those suggested by BIS. ii) The appointment / nomination of independent / non-executive directors to the Board of banks (both public sector and private sector) should be from a pool of professional and talented people to be prepared and maintained by RBI. iii) It would be desirable to take an undertaking from every director to the effect that they have gone through the guidelines defining the role and responsibilities of directors, and understood what is expected of them. iv) In order to ensure strategic focus it would be desirable to separate the office of Chairman and Managing Director in respect of large-sized PSBs. v) The information furnished to the Board should be wholesome, complete and adequate to take meaningful decisions. The Boards focus should be devoted more on strategy issues, risk profile, internal control systems, overall performance, etc. vi) It would be desirable if the exposures of a bank to stockbrokers and market-makers as a group, as also exposures to other sensitive sectors, viz., real estate etc. are reported to the Board regularly. vii) The disclosures of progress made towards establishing progressive risk management system, the risk management policy, strategy, exposures to related entities, the asset classification of such lending / investments etc. should be in conformity with corporate governance standards, etc.

32

CORPORATE GOVERNANCE IN BANKS viii) Finally, the banks could be asked to come up with a strategy and plan for implementation of the governance standards recommended and submit progress of implementation. The Ganguly Committee recommendations have been benchmarked with international best practices as enunciated in the Basel Paper as well as of other Committees and advisory bodies to the extent applicable to the Indian environment. RBI has also implemented most of the recommendations. In general these regulations have created an enabling framework for improving corporate governance in financial institutions. Subsequently, the circular issued on June 25, 2004 on fit and proper criteria for directors of banks enumerated a number of principles; the following among them deserve special mention, viz., i) undertaking a process of due diligence on the part of the banks in private sector to determine the suitability of the person for appointment / continuing to hold appointment as a director on the Board, based upon qualification, expertise, track record, integrity and other fit and proper criteria; ii) the process of due diligence should be undertaken by the banks in private sector at the time of appointment / renewal of appointment; iii) the boards of the banks in private sector should constitute Nomination Committees to scrutinise the declarations; iv) banks should obtain annually, as on March 31, a simple declaration that the information already provided has not undergone change and where there is any change, requisite details are furnished by the directors forthwith.

7.4 MEASURES TAKEN BY BANKS TOWARDS IMPLEMENTATION OF BEST PRACTICES


Prudential norms in terms of income recognition, asset classification, and capital adequacy have been well assimilated by the Indian banking system. In keeping with the international best practice, starting 31st March 2004, banks have adopted 90 days norm for classification of NPAs. Also, norms governing provisioning requirements in respect of doubtful assets have been made more stringent in a phased manner. Beginning 2005, banks will be required

33

CORPORATE GOVERNANCE IN BANKS to set aside capital charge for market risk on their trading portfolio of government investments, which was earlier virtually exempt from market risk requirement. Capital Adequacy: All the Indian banks barring one today are well above the stipulated benchmark of 9 per cent and remain in a state of preparedness to achieve the best standards of CRAR as soon as the new Basel 2 norms are made operational. In fact, as of 31 st March 2004, banking system as a whole had a CRAR close to 13 per cent. On the Income Recognition Front, there is complete uniformity now in the banking industry and the system therefore ensures responsibility and accountability on the part of the management in proper accounting of income as well as loan impairment. ALM and Risk Management Practices At the initiative of the regulators, banks were quickly required to address the need for Asset Liability Management followed by risk management practices. Both these are critical areas for an effective oversight by the Board and the senior management which are implemented by the Indian banking system on a tight time frame and the implementation review by RBI. These steps have enabled banks to understand, measure and anticipate the impact of the interest rate risk and liquidity risk, which in deregulated environment is gaining importance.

7.5 MEASURES TAKEN BY RE G U L AT O R TOWARDS CORPORATE GOVERNANCE


Reserve Bank of India has taken various steps furthering corporate governance in the Indian Banking System. These can broadly be classified into the following three categories: a) Transparency b) Off-site surveillance c) Prompt corrective action Transparency and disclosure standards are also important constituents of a sound corporate governance mechanism. Transparency and accounting standards in India have been enhanced to align with international best practices. However, there are many gaps in the disclosures in India vis--vis the international standards, particularly in the area of risk management strategies and risk parameters, risk concentrations, performance measures, component of capital 34

CORPORATE GOVERNANCE IN BANKS structure, etc. Hence, the disclosure standards need to be further broad-based in consonance with improvements in the capability of market players to analyse the information objectively. The off-site surveillance mechanism is also active in monitoring the movement of assets, its impact on capital adequacy and overall efficiency and adequacy of managerial practices in banks. RBI also brings out the periodic data on "Peer Group Comparison" on critical ratios to maintain peer pressure for better performance and governance. RBI has adopted prompt corrective action as a part of core principles for effective banking supervision. As against a single trigger point based on capita adequacy normally adopted by many countries, Reserve Bank in keeping with Indian conditions have set two more trigger points namely Non-Performing Assets (NPA) and Return on Assets (ROA) as proxies for asset quality and profitability. These trigger points will enable the intervention of regulator through a set of mandatory action to stem further deterioration in the health of banks showing signs of weakness.

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CORPORATE GOVERNANCE IN BANKS

8.

PUBLIC

SECTOR

BANKS

AND

GOVERNANCE

CHALLENGES: INDIAN EXPERIENCE


8.1 Historical Context
India had a fairly well developed commercial banking system in existence at the time of independence in 1947. The Reserve Bank of India (RBI) was established in 1935. While the RBI became a state owned institution from January 1, 1949, the Banking Regulation Act was enacted in 1949 providing a framework for regulation and supervision of commercial banking activity. The first step towards the nationalisation of commercial banks was the result of a report (under the aegis of RBI) by the Committee of Direction of All India Rural Credit Survey (1951) which till today is the locus classicus on the subject. The Committee recommended one strong integrated state partnered commercial banking institution to stimulate banking development in general and rural credit in particular. Thus, the Imperial Bank was taken over by the Government and renamed as the State Bank of India (SBI) on July 1, 1955 with the RBI acquiring overriding substantial holding of shares. A number of erstwhile banks owned by princely states were made subsidiaries of SBI in 1959. Thus, the beginning of the Plan era also saw the emergence of public ownership of one of the most prominent of the commercial banks. There was a feeling that though the Indian banking system had made considerable progress in the 50s and 60s, it established close links between commercial and industry houses, resulting in cornering of bank credit by these segments to the exclusion of agriculture and small industries. To meet these concerns, in 1967, the Government introduced the concept of social control in the banking industry. The scheme of social control was aimed at bringing some changes in the management and distribution of credit by the commercial banks. The close link between big business houses and big banks was intended to be snapped or at least made ineffective by the reconstitution of the Board of Directors to the effect that 51 per cent of the directors were to have special knowledge or practical experience. Appointment of whole-time Chairman with special knowledge and practical experience of working of commercial banks or financial or economic or business administration was intended to professionalise the top

36

CORPORATE GOVERNANCE IN BANKS management. Imposition of restrictions on loans to be granted to the directors concerns was another step towards avoiding undesirable flow of credit to the units in which the directors were interested. The scheme also provided for the take-over of banks under certain circumstances. Political compulsion then partially attributed to inadequacies of the social control, led to the Government of India nationalising, in 1969, 14 major scheduled commercial banks which had deposits above a cut-off size. The objective was to serve better the needs of development of the economy in conformity with national priorities and objectives. In a somewhat repeat of the same experience, eleven years after nationalisation, the Government announced the nationalisation of six more scheduled commercial banks above the cut-off size. The second round of nationalisation gave an impression that if a private sector bank grew to the cut-off size it would be under the threat of nationalisation. From the fifties a number of exclusively state-owned development financial institutions (DFIs) were also set up both at the national and state level, with a lone exception of Industrial Credit and Investment Corporation (ICICI) which had a minority private share holding. The mutual fund activity was also a virtual monopoly of Government owned institution, viz., the Unit Trust of India. Refinance institutions in agriculture and industry sectors were also developed, similar in nature to the DFIs. Insurance, both Life and General, also became state monopolies.

8.2 Pre-Reform Status


The regulatory framework for the banking industry under the Banking Regulation Act was circumscribed by the special provisions of the Bank Nationalisation Act both of which had elements of corporate governance incorporated with regard to composition of Board of Directors in terms of representation of directors, etc. While technically there was competition between banks and non-banks and among banks, substantively, competition was conditioned by policy as well as regulatory environment, common ownership by the Government and agreement between the Government of India as an owner and the workers represented by the Unions. Subsequent efforts during the reform period in terms of hesitancy

37

CORPORATE GOVERNANCE IN BANKS in permitting industrial houses as well as foreign owned banks should be viewed in this historical context. As regards the policy environment, it must be recognised that almost the whole of financial intermediation was on account of public sector, with PSBs being the most important source of mobilization of financial savings. Resources for DFIs were also made available either by banks or mostly created money and governmental support. The major thrust was on expansion of banks branches, provision of banking services and mobilisation of deposits. The interest rate regime was administered with interest rates fixed both on deposits and lending. At the same time, there was large pre-emption of banks resources under the cash reserve ratio or in the form of statutory liquidity ratio. The delivery of credit was also by and large directed through an allocative mechanism or as an adjunct to the licencing regime. In the process, the private sector banks tended to be confined to the local areas and were unable to expand in such an environment. Banks, mainly public sector banks became the most dominant vehicle of the financial intermediation in the country. To a large extent, entry was restricted and exit was impossible and there was little or no scope for functions of risk assessment and pricing of risks. The Government thus combined in itself the role of owner, regulator and sovereign. The legal as well as policy framework emphasized co-ordination in the interest of national development as per Plan priorities with the result, the issue of corporate governance became subsumed in the overall development framework. To the extent each bank, even after nationalization, maintained its distinct identity, governance structure as incorporated in the concerned legislations provided for a formal structure of relationship between the RBI, Government, Board of Directors and management. The role of the RBI 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 PSBs. The SBI, which was owned by the RBI, was in substance no different from the other banks owned by the Government in terms of Board composition, appointment procedures of the executives and non-executive members of the Board of Directors. Both Government and RBI were represented on the Board of Directors of the PSBs. There has been significant cross representation in terms of owner or lender and in other relationships between banks 38

CORPORATE GOVERNANCE IN BANKS and all other major financial entities. In other words, cross holdings and inter-relationships were more a rule than an exception in the financial sector, since the basic objective was coordination for ensuring planned development, with the result, the concepts of conflicts of interests among players, checks and balances etc., were subordinated to the social goals of the joint family headed by the Government.

8.3 Reform Measures


The major challenge of the reform has been to introduce elements of market incentive as a dominant factor gradually replacing the administratively coordinated planned actions for development. Such a paradign shift has several dimensions, the corporate governance being one of the important elements. The evolution of corporate governance in banks, particularly, in PSBs, thus reflects changes in monetary policy, regulatory environment, and structural transformations and to some extent, on the character of the self-regulatory organizations functioning in the financial sector. Policy Environment During the reform period, the policy environment enhanced competition and provided greater opportunity for exercise of what may be called genuine corporate element in each bank to replace the elements of coordinated actions of all entities as a "joint family" to fulfill predetermined Plan priorities. The measures taken so far can be summarized as follows : First, greater competition has been infused in the banking system by permitting entry of private sector banks (9 licences since 1993), and liberal licensing of more branches by foreign banks and the entry of new foreign banks. With the development of a multiinstitutional structure in the financial sector, emphasis is on efficiency through competition irrespective of ownership. Since non-bank intermediation has increased, banks have had to improve efficiency to ensure survival. Second, the reforms accorded greater flexibility to the banking system to manage both the pricing and quantity of resources. There has been a reduction in statutory preemptions to less than a third of commercial banks resources. The mandatory component of market financing

39

CORPORATE GOVERNANCE IN BANKS of Government borrowing has decreased. While directed credit continues it is now on near commercial terms. Valuation of banks' investments is also attuned to international best practices so as to appropriately capture market risks. Third, the RBI has moved away from micro-regulation to macro-management. RBI has replaced detailed individual guidelines with general guidelines and now leaves it to individual banks boards to set their guidelines on credit decisions. A Regulation Review Authority was established in RBI, whereby any bank could challenge the need for any regulation or guideline and the department had to justify the need and usefulness for such guideline relative to costs of regulation and compliance. Fourth, to strengthen the banking system to cope up with the changing environment, prudential standards have been imposed in a progressive manner. Thus, while banks have greater freedom to take credit decisions, prudential norms setting out capital adequacy norms, asset classification, income recognition and provisioning rules, exposure norms, and asset liability management systems have helped to identify and contain risks, thereby contributing to greater financial stability. Fifth, an appropriate legal, institutional, technological and regulatory framework has been put in place for the development of financial markets. There is now increased volumes and transparency in the primary and secondary market operations. Development of the Government Securities, money and forex markets has improved the transmission mechanism of monetary policy, facilitated the development of an yield curve and enabled greater integration of markets. The interest rate channel of monetary policy transmission is acquiring greater importance as compared with the credit channel. Regulatory Environment Prudential regulation and supervision have formed a critical component of the financial sector reform programme since its inception, and India has endeavoured to international prudential norms and practices. These norms have been progressively tightened over the years, particularly against the backdrop of the Asian crisis. Bank exposures to sensitive sectors such as equity and real estate have been curtailed. The Banking Regulation Act 1949 40

CORPORATE GOVERNANCE IN BANKS prevents connected lending (i.e. lending by banks to directors or companies in which Directors are interested). Periodical inspection of banks has been the main instrument of supervision, though recently there has been a move toward supplementary 'on-site inspections' with 'off-site surveillance'. The system of 'Annual Financial Inspection' was introduced in 1992, in place of the earlier system of Annual Financial Review/Financial Inspections. The inspection objectives and procedures, have been redefined to evaluate the banks safety and soundness; to appraise the quality of the Board and management; to ensure compliance with banking laws & regulation; to provide an appraisal of soundness of the bank's assets; to analyse the financial factors which determine bank's solvency and to identify areas where corrective action is needed to strengthen the institution and improve its performance. Inspection based upon the new guidelines have started since 1997. A high powered Board for Financial Supervision (BFS), comprising the Governor of RBI as Chairman, one of the Deputy Governors as Vice-Chairman and four Directors of the Central Board of RBI as members was constituted in 1994, with the mandate to exercise the powers of supervision and inspection in relation to the banking companies, financial institutions and non-banking companies. A supervisory strategy comprising on-site inspection, off-site monitoring and control systems internal to the banks, based on the CAMELS (capital adequacy, asset quality, management, earnings, liquidity and systems and controls) methodology for banks have been instituted. The RBI has instituted a mechanism for critical analysis of the balance sheet by the banks themselves and the presentation of such analysis before their boards to provide an internal assessment of the health of the bank. The analysis, which is also made available to the RBI, forms a supplement to the system of off-site monitoring of banks. Keeping in line with the merging regulatory and supervisory standards at international level, the RBI has initiated certain macro level monitoring techniques to assess the true health of the supervised institutions. The format of balance sheets of commercial banks have now been prescribed by the RBI with disclosure standards on vital performance and growth

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CORPORATE GOVERNANCE IN BANKS indicators, provisions, net NPAs, staff productivity, etc. appended as 'Notes of Accounts'. To bring about greater transparency in banks' published accounts, the RBI has also directed the banks to disclose data on movement of non-performing assets (NPAs) and provisions as well as lending to sensitive sectors. These proposed additional disclosure norms would bring the disclosure standards almost on par with the international best practice. Structural Environment of Banking The nationalized banks are enabled to dilute their equity of Government of India to 51% following the amendment to the Banking Companies (Acquisition & Transfer of Undertakings) Acts in 1994, bringing down the minimum Government's shareholdings to 51 per cent in PSBs. RBI's shareholding in SBI is subject to a minimum of 55 per cent. Ten banks have already raised capital from the market. The Government proposed, in the Union Budget for the financial year 2000-01 to reduce its holding in nationalised banks to a minimum of 33 per cent, while maintaining the public sector character of these banks. The diversification of ownership of PSBs has made a qualitative difference to the functioning of PSBs since there is induction of private shareholding and attendant issues of shareholders value, as reflected by the market cap, representation on board, and interests of minority shareholders. There is representation of private shareholder when the banks raise capital from the market. The governance of banks rests with the board of directors. In the light of deregulation in interest rates and the greater autonomy given to banks in their operations, the role of the board of directors has become more significant. During the years, Boards have been required to lay down policies in critical areas such as investments, loans, asset-liability management, and management and recovery of NPAs. As a part of this process, several Board level committees including the Management Committee are required to be appointed by banks. In 1995, the RBI directed banks to set up Audit Committees of their Boards, with the responsibility of ensuring efficacy of the internal control and audit functions in the bank besides compliance with the inspection report of the RBI, internal and concurrent auditors. To ensure both professionalism and independence, the Chartered Accountant Directors on

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CORPORATE GOVERNANCE IN BANKS the boards of banks are mandatory members, but the Chairman would not be part of the Audit Committee. Apart from the above, Board level committees that are required to be set up are Risk Management committee, Asset Liability Management committee (ALCO), etc. The Boards have also been given the freedom to constitute any other committees, to render advice to it. Government introduced a Bill in Parliament to omit the mandatory provisions regarding appointment of RBI nominees on the Boards of public sector banks and instead to add a clause to enable RBI to appoint its nominee on the boards of public sector banks if the RBI is of the opinion that in the interest of the banking policy or in the public interest or in the interest of the bank or depositors, it is necessary so to do. As regards, appointment of Additional Directors on the Boards of private sector banks, since December 1997, the RBI has been appointing such directors only in such of those 'banks making losses for more than one year, having CRAR below 8%, NPAs exceeding 20% or where there are disputes in the management. Government does appointment of Chairman and Managing Directors and Executive Directors of all PSBs. The Narasimham Committee II had recommended that the appointment of Chairman and Managing Director should be left to the Boards of banks and shareholders should elect the Boards themselves. Government has set up an Appointment Board chaired by Governor, Reserve Bank of India for these appointments. More recently, in case of appointment of Chief Executive Officer of the PSBs identified as weak, the Government has formed a Search Committee with two outside experts. Appointment as well as removal of auditors in PSBs requires prior approval of the RBI. There is an elaborate procedure by which banks select auditors from an approved panel circulated by the RBI. In respect of private sector banks, the RBI appoints the statutory auditors in the Annual General Meeting with the prior approval.

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CORPORATE GOVERNANCE IN BANKS Self Regulatory Organizations India has had the distinction of experimenting with Self Regulatory Organisations (SROs) in the financial system since the pre-independence days. At present, there are four SROs in the financial system - Indian Banks Association (IBA), Foreign Exchange Dealers Association of India (FEDAI), Primary Dealers Association of India (PDAI) and Fixed Income Money Market Dealers Association of India (FIMMDAI). The IBA established in 1946 as a voluntary association of banks, strove towards strengthening the banking industry through consensus and co-ordination. Since nationalization of banks, PSBs tended to dominate IBA and developed close links with Government and RBI. Often, the reactive and consensus and coordinated approach bordered on cartelisation. To illustrate, IBA had worked out a schedule of benchmark service charges for the services rendered by member banks, which were not mandatory in nature, but were being adopted by all banks. The practice of fixing rates for services of banks was consistent with a regime of administered interest rates but not consistent with the principle of competition. Hence, the IBA was directed by the RBI to desist from working out a schedule of benchmark service charges for the services rendered by member banks. Responding to the imperatives caused by the changing scenario in the reform era, the IBA has, over the years, refocused its vision, redefined its role, and modified its operational modalities. In the area of foreign exchange, FEDAI was established in 1958, and banks were required to abide by terms and conditions prescribed by FEDAI for transacting foreign exchange business. In the light of reforms, FEDAI has refocused its role by giving up fixing of rates, but plays a multifarious role covering training of banks personnel, accounting standards, evolving risk measurement models like the VaR and accrediting foreign exchange brokers. In the financial markets, the two SROs, viz., the PDAI and the FIMMDAI are of recent origin i.e. 1996 and 1997. These two SROs have been proactive and are closely involved in contemporary issues relating to development of money and government securities markets. The representatives of PDAI and FIMMDAI are members of important committees of the 44

CORPORATE GOVERNANCE IN BANKS RBI, both on policy and operational issues. To illustrate, the Chairmen of PDAI and FIMMDAI are members of the Technical Advisory Group on Money and Government Securities market of the RBI. These two SROs have been very proactive in mounting the technological infrastructure in the money and Government Securities markets. The FIMMDAI has now taken over the responsibility of publishing the yield curve in the debt markets. Currently, the FIMMDAI is working towards development of uniform documentation and accounting principles in the repo market.

8.4 Assessment of Corporate Governance in PSBs


A Standing Committee on International Financial Standards and Codes was constituted to, inter alia, assess the status in India vis--vis the best global practices in regard to standards and codes. An Advisory Group on Corporate Governance (Chairman: Dr. R. H. Patil) made detailed assessment and gave recommendations of which those relating to PSBs is an important component. The Report provides the most comprehensive set of recommendations on the subject, summarized in Box 1. Advisory Group on Corporate Governance

Currently in India, about four-fifths of the banking business is under the control of public sector banks (PSBs), comprising the SBI and its subsidiaries and the nationalized banks. Corporate governance in PSBs is complicated by the fact that effective management of these banks vests with the government and the top managements and the boards of banks operate merely as functionaries. The ground reality is such that the government performs simultaneously multiple functions vis-vis the PSBs, such as the owner, manager, quasi-regulator, and sometimes even as the super-regulator. Unless the issues connected with these multiple, and sometimes conflicting, functions are resolved and the boards of banks are given the desired level of autonomy it would be difficult to improve the quality of corporate governance in PSBs. One of the major factors that impinge directly on the quality of corporate governance is the government ownership. It is desirable that all the banks are brought under a single Act so that the corporate governance regimes do not have to

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CORPORATE GOVERNANCE IN BANKS 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.

Even when the government dilutes its holdings to bring them significantly below the threshold limit of 51 per cent, efforts to institute good governance practices would remain at superficial level unless the government seriously redefines its role de novo. The changes proposed in the composition of the boards as per legislation under contemplation would result in government directly appointing 9 out of the 15 directors including the 4 whole time directors. Moreover, the voting rights of any of the other shareholders will continue to be restricted, thereby negating the basic principle of equal rights to all the shareholders. The rights of private shareholders of SBI/PSBs are abridged considerably, since their approval is not required for paying dividend or adopting annual accounts. The subsidiaries of the SBI enjoy very limited board autonomy as they have to get clearance on most of the important matters from the parent even before putting them up to their boards. Further, as things stand today, there is no equality among the various board members of the PSBs. Nominees of RBI and Government are treated to be superior to other directors.

Another major problem affecting banks has been the representation given to the various interest groups on the boards of the banks. The main objective behind these representations was to give voice to various sections of the society at the board level of the banks. Hence, a major reform is needed in the area of constitution of the boards of the banks. The Chairmen, Executive Directors and non-executive directors on the boards of the PSBs (including the SBI and its subsidiaries) need to be appointed on the advice of an expert body set up on the lines of the UPSC, with similar status and independence. Such a body may be set up jointly by RBI and the Ministry of Finance. There is also no need to have directors that represent narrow sectional and economic interests. All the objectives that the banks are supposed to achieve should become an integral part of the corporate mission statements of these institutions.

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Although RBI maintains a tight vigil and inspects these entities thoroughly at regular time intervals, the quality of corporate level governance mechanism does not appear to be satisfactory. In its role as the regulator, RBI need not have representation on the bank boards, given the fact that it leads to conflicts of interests with its regulatory functions. This should apply even in the case of SBI where RBI is the major shareholder. 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.

Current regulatory provisions do not permit a bank to lend money to a company if any of its board members is also a director on the board of that company. The negative impact of this rule has been that the banks are not able to get good professionals for their boards. This archaic rule should be modified immediately so that the professionals who are on the boards of non-banking companies as professional or independent directors do not suffer from any handicaps. The current rule may, however, be continued only in respect of directors of companies who are their promoters and have a stake in their companies beyond being merely a director. In the interest of good governance, it is desirable that government directors should not participate in the discussion on such matters and also abstain from voting.

The Report of the Advisory Group on Banking Supervision (Chairman : Mr. M.S. Verma) has also made some recommendations on corporate governance, which are summarised in Advisory Group on Banking Supervision

The quality of corporate governance should be the same in all types of banking organisations irrespective of their ownership. The process of induction of directors into banks boards and their initial orientation may be streamlined. Banks need to develop mechanisms, which can help them ensure percolation of their strategic objectives and corporate values throughout the organisation. Boards need to set and enforce clear lines of responsibility and accountability for themselves as well as the senior management and throughout the organisation. Linkage between contribution

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CORPORATE GOVERNANCE IN BANKS and remuneration/reward should be established. Compensation Committees of the board could be set up for the purpose. Nomination Committees to assess the effectiveness of the board and direct the process of renewing and replacing board members are desirable. Disclosures in respect of committees of the board and qualifications of the directors, incentive structure and the nature and extent of transactions with affiliated and related parties need to be encouraged. Finally, a provision on the lines of Section 20 of the Banking Regulation Act, 1949, which prohibits loans and advances to directors and their connected parties, will have to be made in respect of large shareholders also. Information on transactions with affiliated and related parties should be disclosed. Current Proposal It would be evident that the Reports of Advisory Groups contain far reaching proposals to improve corporate governance and many, if not all, do require legislative processes and they are necessarily time consuming and often realizable only in medium-term. While proceeding with analysis and possible legislative actions, it may be necessary to consider and adopt changes that could be brought about within the existing legislative framework. To this end, Governor Jalan in his Monetary and Credit Policy Statement of October 2001 constituted a Consultative Group of Directors of banks and financial institutions (Chairman Dr. A.S. Ganguly) to review the supervisory role of Boards of banks and financial institutions and to obtain feedback on the functioning of the Boards vis--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 recently 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. The report has been put in public domain for a wider debate and its major recommendations are summarized in Box 3 :

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CORPORATE GOVERNANCE IN BANKS Report of the consultative group of directors

of banks/financial institutions

On appointment of Directors, due diligence of the directors of all banks be they in public or private sector, should be done in regard to their suitability for the post by way of qualifications and technical expertise. Involvement of Nomination Committee of the Board in such an exercise should be seriously considered as a formal process. Further, the Government while nominating directors on the Boards of public sector banks should be guided by certain broad "fit and proper" norms for the Directors. The criteria suggested by the Bank for International Settlements (BIS) may be suitably adopted for considering "fit and proper" test for bank directors.

In the present context of banking becoming more complex and knowledge-based, there is an urgent need for making the Boards of banks more contemporarily professional by inducting technical and specially qualified individual. While continuing regulation based representation of sectors like agriculture, SSI, cooperation, etc., the appointment/nomination of independent/ non-executive directors to the Board of banks (both public sector and private sector) should be from a pool of professional and talented people to be prepared and maintained by RBI. Any deviation from this procedure by any bank should be with the prior approval of RBI.

On the functioning, the independent/non-executive directors should raise in the meetings of the Board, critical questions relating to business strategy, important aspects of the functioning of the bank and investor relations. In the case of private sector banks where promoter directors may act in concert, the independent/nonexecutive directors should provide effective checks and balances ensuring that the bank does not build up exposures to entities connected with the promoters or their associates. The independent/non-executive directors should provide effective checks and balances particularly, in widely held and closely controlled banking organizations.

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As a step towards effective corporate governance, it would be desirable to take an undertaking from every director to the effect that they have gone through the guidelines defining the role and responsibilities of directors, and understood what is expected of them and enter into a covenant to discharge their responsibilities to the best of their abilities, individually and collectively.

In order to attract quality professionals, the level of remuneration payable to the directors should be commensurate with the time required to be devoted to the banks work as well as to signal the appropriateness of remuneration to the quality of inputs expected from a member. The statutory prohibition under section 20 of the Banking Regulation Act, 1949 on lending to companies in which the director is interested, severely constricts availability of quality professional directors on to the Boards of banks. This would require a change in the existing legal framework. We need to move towards this goal.

It would be desirable to separate the office of Chairman and Managing Director in respect of large sized public sector banks. This functional separation 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. The directors could be made more responsible to their organization by exposing them to an induction briefing needbased training programme/seminars/workshops to acquaint them with emerging developments/challenges facing the banking sector. RBI as the regulator, could take the initiative to organizing such seminars. RBI may bring out an updated charter indicating clear-cut, specific guidelines on the role expected and the responsibilities of the individual directors. The whole-time directors should have sufficiently long tenure to enable them to leave a mark of their leadership and business acumen on the banks performance. All banks should consider appointing qualified Company Secretary as the Secretary to the Board and have a Compliance Officer (reporting to the Secretary) for monitoring and reporting compliance with various regulatory/accounting requirements.

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CORPORATE GOVERNANCE IN BANKS

The information furnished to the Board should be wholesome, complete and adequate to take meaningful decisions. A distinction needs to be made between statutory items and strategic issues in order to make the material for directors manageable. The Reviews dealing with various performance areas could be put up the Supervisory Committee of Board and a summary of each such review could be put up to the Main Board. The Boards focus should be devoted more on strategy issues, risk profile, internal control systems, overall performance, etc. The procedure followed for recording of the minutes of the board meetings in banks and financial institutions should be uniform and formalized. Banks and financial institutions may adopt two methods for recording the proceedings viz., a summary of key observations and a more detailed recording of the proceedings.

It would be desirable if the exposures of a bank to stockbrokers and market-makers as a group, as also exposures to other sensitive sectors, viz., real estate etc. are reported to the Board regularly. The disclosures in respect of the progress made in putting in place a progressive risk management system, the risk management policy, strategy followed by the bank, exposures to related entities, the asset classification of such lendings/investments etc. conformity with Corporate Governance Standards etc., be made by banks to the Board of Directors at regular intervals as prescribed.

As regards Committees, there could be a Supervisory Committee of the Board in all banks, be the public or private sector, which will work on collective trust and at the same time, without diluting the overall responsibility of the Board. Their role and responsibilities could include monitoring of the exposures (credit and investment) review of the adequacy of risk management process and upgradation thereof, internal control systems and ensuring compliance with the statutory/regulatory framework. The Audit Committee should, ideally be constituted with independent/non-executive directors and the Executive Director should only be a permanent invitee. However, in respect of public sector banks, the existing arrangement of including the Executive Director and nominee directors of Government and RBI in the Audit Committee may continue. The Chairman and Audit Committee need not be confined to the Chartered Accountant profession but can be a person with knowledge on finance or banking 51

CORPORATE GOVERNANCE IN BANKS so as to provide directions and guidance to the Audit Committee, since the Committee not only looks at accounting issues, but also the overall management of the bank. It is desirable to have a Nomination Committee for appointing independent/non-executive directors of banks. In the context of a number of public sector banks issuing capital to the public, a Nomination Committee of the Board may be formed for nomination of directors, representing shareholders. The formation and operationalisation of the Risk Management Committees in pursuance of the guidelines issued by the RBI should he speeded up and their role further strengthened. With a view of building up credibility among the investor class, the Group recommends that a Committee of the Board may be set up to look into the grievance of investors and shareholders, with the Company Secretary as a nodal point.

Finally the banks could be asked to come up with a strategy and plan for implementation of the governance standards recommended and submit progress of implementation, for review after twelve months and thereafter half yearly or annually, as deemed appropriate.

8.5 Tentative Issues and Lessons


The Indian experience shows recognition of (a) the importance of corporate governance and the challenges in redefining institutional relations in the financial sector in respect of PSBs; (b) the need for a broader view of enhancing corporate governance to take account of law and policy as well as the operating and institutional environment; and (c) the desirable changes in the composition and functioning of the board. The processes by which some progress has been made so far and actions contemplated are also instructive needless to add that these issues and lessons have to be viewed as tentative, and of course, contextual. Corporate governance in PSBs is important, not only because PSBs 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 PSBs, the multiple objectives of the government as owner and the complex principal-agent relationships cannot

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CORPORATE GOVERNANCE IN BANKS be wished away. PSBs cannot be expected to blindly mimic private corporate banks in governance though general principles are equally valid. Complications arise when there is a widespread feeling of uncertainty of the ownership and public ownership is treated as a transitional phenomenon. The anticipation or threat of change in ownership has also some impact on governance, since expected change is not merely of owner but the very nature of owner. Mixed ownership where government has controlling interest is an institutional structure that poses issues of significant difference between one set of owners who look for commercial return and another who seeks something more and different, to justify ownership. 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 PSBs should be recognized. In brief, the issue of corporate governance in PSBs is important and also complex. 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, RBI and PSBs to move away from "joint family" approach originally designed for a model of planned development. As part of reform the government had to differentiate, conceptually and at the policy level, its role as sovereign, owner of banks and overarching supervisor of regulators including RBI. The central bank also had to 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. Furthermore, the bureaucracy of RBI is accountable to the RBIs Board for Financial Supervision. The large publicly owned non-financial enterprise had to recognize the need for a more commercial and competitive approach with banks including PSBs in raising of and deployment of funds. Similarly, the PSBs had to reorient their approach to each other also with intensified competition engineered by policy while guarding against excessive risk taking as dictated by a supervisor seeking to meet international standards. Another noteworthy aspect of enhancing corporate governance is the narrowing of gap between PSBs and other banks in terms of the policy, regulatory and operating environment, apart from some changes in ownership structures with attendant consequences. The PSBs as 53

CORPORATE GOVERNANCE IN BANKS hundred per cent owned entities with no share value quoted in stock exchanges accounted for over three quarters of banking business seven years ago, while they now account for less than a quarter. A third area where a few changes to enhance quality of governance have been made or are contemplated relates to the manner in which chief executives are selected, the board is composed in view of induction of some elected directors, and the constitution of committees, including the Audit Committee. In this regard, it is noteworthy that recently, the functioning of bank boards in the private sector seems to have attracted significant adverse notice, both from market and supervisor. That the representation of RBI on the Boards is not desirable has been conceded just as RBI has expressed interest in divesting all its ownership functions. The processes by which these changes have been and are being brought about may also be of some interest. First, RBI has taken initiative in bringing about changes rather than "keep aloof" from the regulated entities as pure theory may suggest. The developmental role of RBI, which was in the nature of promoting and funding of institutions or channeling credit to schemes under government approved plans has yielded place to the role of developer of a more robust financial system, especially banking structure and system. Sometimes, closer involvement of RBI in some transitional arrangements, such as in advising government on appointment of Chief Executives of PSBs was needed to bring about changes. The professional inputs as well as sensitising and creating opinion to enhance corporate governance was ensured by RBI through the Advisory Groups and Consultative Group mentioned. Second, as Governor Jalan in his National Institute of Bank Management (NIBM) Annual Day Lecture articulated, markets are more free and more complex now; what happens in banks is a concern for all since there is fear of contagion and above all we live in a more volatile and interlinked world where effects are instantaneous. (Jalan 2002). Hence, in the process of making markets more free as part of the reform, RBI had to discharge its responsibility of equipping the participants, especially the most dominant segment viz., PSBs, to manage the complexities or simply to cope. Hence, RBI had taken initiatives in

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CORPORATE GOVERNANCE IN BANKS improving the competitive strengths as well as governance systems of PSBs while pursuing its objective of distancing, as a regulator, from the operational closeness with both government which is an owner of PSB, and PSBs which are the regulated. Thirdly, the path of reform of which corporate governance is one element had to be considered carefully and evolved through a consultation and participation process at every step. Thus, the basic framework was provided by Narasimham Committees 1 and 2 in which all stakeholders were represented followed by a series of Committees and Consultation Papers to refine and redefine and apply the basic framework. The collaborative and consensual approach in the path of reform was adopted while the goals of reforms were to the extent possible well defined. The most recent example of this approach has been described in the Report of the Advisory Groups on various International Standards and Codes. Fourthly, there was need to resist the temptation of demoralising the PSBs on presumed inefficiency, and make every effort to enable and empower them to meet the challenges. There has been clear recognition that governance is not merely one of structures, but also one of culture and this requires careful nurture. This has been made possible by a variety of mechanisms and through a variety of fora. One illustration would suffice to reflect the changing attitude of the RBI in this regard. The Governor, RBI who was the Chairman of National Institute of Bank Management yielded the position to a former Chairman of a public sector bank and the RBI distanced itself from the day to day running of the Institute without withdrawing its interest and support. Fifthly, the importance of SROs in bringing about change has been recognised and the orientation of pre-existing institutions, in particular, Indian Banks Association, has changed to meet new challenges. Various mechanisms have been found to ensure an environment supportive of sound corporate governance mentioned in BIS Document (BIS September 1999) by not only pursuing legal and policy changes with the Government, but also close interaction with auditors and banking industry associations.

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8.6 Random Thoughts


The Indian experience provokes some thoughts on a few fundamental issues in regard to PSBs and corporate governance. First, is public ownership compatible with sound corporate governance as generally understood? Since various corporate governance structures exist in different countries, there are no universally correct parameters of sound corporate governance. Government ownership of a bank, unless government happens to have such a stake purely as a financial investment for return, necessarily has to have the effect of altering the strategies and objectives as well as structure of governance. Government as an owner is accountable to political institutions which may not necessarily be compatible with purely economic incentives. The mixed ownership brings into sharper focus the divergent objectives of shareholding and the issues of reconciling them, especially when one of the owners is government. In such a situation, one can argue that as long as the private shareholder is aware of the special nature of shareholding, there should be no conflict. In other words, the idea of maintaining public sector character of a bank while government holds a minority shareholding is an intensified and modified version of "golden share" experiment of U.K. The question could still be as to whether such a mixed ownership is the most efficient form of organization, particularly for banks which are in any case generally under intense regulation and supervision. Second, is corporate governance generally better in private sector, in particular, private sector banks? In regard to old private sector banks (i.e. founded in pre-reform era, almost all of them continue to be closely held and many of them resist broadening their shareholder base and thus avoid deepening of corporate structures. More often than not, takeover bids have been by equally closely held groups. As regards new private sector banks, which have been licensed after close scrutiny in the reform period, the promotees were expected to dilute their stakes to below 40 per cent within three years. In two of the cases, this is yet to happen, while in most cases, the banks continue to be identified with effective controlled by promoter institutions. Governor Jalan, made an interesting observation on this in a recent lecture. "By and large, the structure is very weak in Co-operatives and NBFCs for historical reasons, local practices, and multiplicity of regulators and laws. Old private sector banks also have very poor auditing and accounting systems. New private banks generally good 56

CORPORATE GOVERNANCE IN BANKS on accounting, but poor on accountability. More modern and computerized, but less risk conscious. One thing which is common to all is that corporate governance is highly centralized with very little real check on the CEO, who is generally also closely linked to the largest owner groups. Boards or auditing systems are not very effective." (Jalan 2002) Third, how do the dynamics of insider and outsider models in terms of separation between ownership and management work in public vis--vis private sector banks? One view is that there is not much difference between public and private sectors in India. "The literature on the governance deals mostly with the financial disclosures and restrictions on the managements that remain within the corporation and the influence that the external stakeholder or shareholders can hold. But in developing countries, the problem is slightly the other way round. In developing countries and more particularly in India, the major corporate issue is not how outside financiers can control the actions of the managers but also how outside stakeholders including the minority shareholders can exert control over the big inside shareholders; and this does not apply only to the public sector, but it applies equally strongly or probably more strongly to the private sector as well." (Bhide 2002). There are, however, significant elements of subjectivity. Governor Jalan feels that private sector has greater elements of insider model. "Public sector banks/FIs, for example, are more akin to the outsider model with separation of "Ownership" and "Management". Private sector banks/NBFCs/Co-ops - much more "insider" models with families, inter-connected entities or promoters running the management." (Jalan 2002) The dominant view, backed by more recent research is that the issue in India often relates to minority shareholder. "Rather than conflict between owners and managers of firms, it is the conflict between the interests of minority shareholders and promoters (say business groups) that is more relevant for India and that needs to be addressed. " (NSE 2001). In other words, if the governance structures are weak, the risks of private ownership of banks need to be assessed before embarking on large scale privatizations. Fourth, is the performance of PSBs vis--vis private sector demonstrably better? The evidence here is not conclusive, because comparison is beset with several difficulties.

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CORPORATE GOVERNANCE IN BANKS Clearly, old private sector banks as a group do not perform well, while new private sector banks show good performance as a group better than the PSBs as a group. Given the size and variety of PSBs, it is possible to find banks that could equal the good private sector banks as well as bad ones. In addition, PSBs have to reckon the "legacy" problems, such as the non performing assets that they are saddled with. Some PSBs operate in relatively backward areas with limited discretion for management to pull out from such areas. The question still remains: whether there is a better pay off in enabling PSBs to improve their performance while promoting private sector banks compared to transfer of ownership and control from public to private sector? Will greater scope for mergers and acquisitions within and between public and private sector add to greater efficiency than treating public and private in a watertight manner? Finally, what should be the most operationally relevant approach for enhancing governance in PSBs recognizing that the extent of public ownership is determined predominantly by considerations of political economy while the functioning of institutions could possibly be influenced by techno-economic factors. The Indian experience so far, including identified agenda for debtate, seems to indicate that, clear cut demarcation of responsibilities of various institutions and participants is critical since "joint family approach" needs to be ended with friendly but amicable "partition" of assets, liabilities and activities. This needs to be accompanied by transparency in dealing with each other and proper accounting of transactions which would be significantly in the areas of managerial reporting and financial accounting. Simultaneously, checks and balances should be consciously put in place to replace the tradition of all pervading bureaucratic coordination. In brief, central bank has a developmental role even in the period of reform but it is a different type of role, namely not directly financing development but help develop systems, institutions and procedures to enable a paradigm shift in public policy and in the process enhance corporate governance also in PSBs, in particular. While legislative changes are necessary for an enduring improvement in corporate governance and such legislative changes are not easy to effect in a democratic multi-party Parliamentary system, it is reassuring to observe that significant improvements in corporate governance in the Indian financial sector are being effected even within the existing legislative framework. 58

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9. A COMPREHENSIVE POLICY FRAMEWORK FOR OWNERSHIP AND GOVERNANCE IN PRIVATE SECTOR BANKS

Introduction
Banks are 'special' as they not only accept and deploy large amount of uncollateralized public funds in fiduciary capacity, but also they leverage such funds through credit creation. They are also important for smooth functioning of the payment system. In view of the above, legal prescriptions for ownership and governance of banks laid down in Banking Regulation Act, 1949 have been supplemented by regulatory prescriptions issued by RBI from time to time. The existing legal framework and significant current practices in particular cover the following aspects: i. The composition of Board of Directors comprising members with demonstrable professional and other experience in specific sectors like agriculture, rural economy, cooperation, SSI, law, etc., approval of Reserve Bank of India for appointment of CEO as well as terms and conditions thereof, and powers for removal of managerial personnel, CEO and directors, etc. in the interest of depositors are governed by various sections of the B. R. Act, 1949. ii. Guidelines on corporate governance covering criteria for appointment of directors, role and responsibilities of directors and the Board, signing of deed by covenants by directors, etc., was issued by RBI on June 20, 2002, based on the recommendations of Ganguly Committee and a review by the BFS. iii. Guidelines for acknowledgement of transfer / allotment of shares in private sector banks was issued in the interest of transparency by RBI on February 3, 2004 (Annexure). iv. v. Foreign investment in the banking sector is governed vide Press Note dated March 5, 2004 issued by the Government of India, Ministry of Commerce and Industries. The earlier practice of RBI nominating directors on the Boards of all private sector

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CORPORATE GOVERNANCE IN BANKS banks has yielded place to such nomination in select private sector banks. Against this background, it is considered necessary to lay down a comprehensive framework of policy in a transparent manner relating to ownership and governance in the Indian private sector banks as described below. The broad principles underlying the framework of policy relating to ownership and governance of private sector banks would have to ensure that: i. ii. The ultimate ownership and control of private sector banks is well diversified. Important Shareholders (i.e., shareholding of 5 per cent and above) are fit and proper, as laid down in the guidelines dated February 3, 2004 on acknowledgement for allotment and transfer of shares. iii. iv. v. vi. The directors and the CEO who manage the affairs of the bank are 'fit and proper' and observe sound corporate governance principles. To avoid conflict of interest, RBI will not appoint its nominee on the Boards of private sector banks unless there are exceptional circumstances. Private sector banks have minimum capital / net worth for optimal operations and systemic stability. The policy and the processes are transparent and fair.

Minimum capital
The capital requirement of existing private sector banks should be on par with the entry capital requirement for new private sector banks prescribed in RBI guidelines of January 3, 2002, which is initially Rs.200 crore, with a commitment to increase to Rs.300 crore within three years. In order to meet with this requirement, all banks in private sector should have a net worth of Rs 300 crore at all times. Where the net worth declines to level below Rs 300 crore, it should be restored within reasonable time.

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Shareholding
i. The RBI guidelines on acknowledgement for acquisition or transfer of shares issued on February 3, 2004 will be applicable for any acquisition of shares of 5 per cent and above of the paid up capital of the private sector bank. ii. In the interest of diversified ownership of banks, the objective will be to ensure that no single entity or group of related entities has shareholding or control, directly or indirectly, in any bank in excess of 10 per cent of the paid up capital of the private sector bank. Any higher level of acquisition will be with the prior approval of RBI and in accordance with the guidelines of February 3, 2004 for grant of acknowledgement for acquisition of shares. iii. Where ownership is that of a corporate entity, the objective will be to ensure that no single individual/entity has ownership and control in excess of 10 per cent of that entity. Where the ownership is that of a financial entity the objective will be to ensure that it is a widely held entity, publicly listed and a well established regulated financial entity in good standing in the financial community. iv. In respect of a new license for private sector banks, promoter shareholding may be allowed to be higher to start with as at present, but will be required to be brought down to the limit of 10 per cent in a time bound manner normally within a period of three years. v. As per existing policy, large industrial houses will not be allowed to set up banks but will be permitted to acquire by way of strategic investment shares not exceeding 10 per cent of the paid up capital of the bank subject to RBI's prior approval. vi. Any private sector bank will be allowed to hold shares in any other private sector bank only upto 5 per cent of the paid up capital of the investee bank. On the same analogy, any foreign bank with presence in India will be allowed to hold shares in

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CORPORATE GOVERNANCE IN BANKS any other private bank only upto 5 per cent of the paid up capital of the investee bank.

Directors and Corporate Governance


i. The recommendations of the Ganguly Committee on corporate governance in banks have highlighted the role envisaged for the Board of Directors. The Board of Directors should ensure that the responsibilities of directors are well defined and the banks should arrange need-based training for the directors in this regard. While the respective entities should perform the roles envisaged for them, private sector banks will be required to ensure that the directors on their Boards representing specific sectors as provided under the B. R. Act, are indeed representatives of those sectors in a demonstrable fashion, they fulfill the criteria under corporate governance norms provided by the Ganguly Committee and they also fulfill the criteria applicable for determining 'fit and proper' status of Important Shareholders (i.e., shareholding of 5 per cent and above). ii. As a matter of desirable practice, not more than one member of a family or a close relative (as defined under Section 6 of the Companies Act, 1956) or an associate (partner, employee, director, etc.) should be on the Board of a bank. iii. Guidelines have been provided by the Ganguly Committee on Corporate Governance according to which a covenant has to be signed by all the directors on the Boards of the banks. All directors will be required to sign the covenant in 'public interest'. iv. Being a Director, CEO should satisfy the requirements of the 'fit and proper' criteria applicable for directors. In addition RBI may apply any additional requirements for the Chairman and CEO. The banks will be required to provide all information that may be required while making application to RBI for approval of appointment of Chairman /CEO.

Foreign investment in private sector banks

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In terms of the recent GOI press note of March 5, 2004, the aggregate foreign investment in private banks from all sources (FDI, FII, NRI) cannot exceed 74 per cent. The limit of 74 per cent will be reckoned by taking the direct and indirect holding. At all times, at least 26 per cent of the paid up capital of the private sector bank will have to be held by residents. Foreign Direct Investment (FDI) i. The policy already articulated in the February 3, 2004 guidelines for determining fit and proper status of shareholding of 5 per cent and above will be equally applicable for FDI. Hence any FDI in private banks where shareholding reaches and exceeds 5 percent either individually or as a group will have to comply with the criteria indicated in the aforesaid guidelines. ii. In the interest of diversified ownership, the percentage of FDI by single entity or group of related entities may not exceed 10 percent. Foreign Institutional Investors (FIIs) i. Currently there is a limit of 10 per cent for individual FII investment with the aggregate limit for all FIIs restricted to 24 per cent which can be raised to 49 per cent with the approval of Board / General Body. This dispensation will continue. ii. The present policy of RBIs acknowledgement for acquisition/ transfer of shares of 5 percent and more of a private sector bank by FIIs will continue and will now be based upon the policy guidelines on acknowledgement of acquisition/transfer for shares issued on February 3, 2004. For this purpose RBI may seek certification from the concerned FII of all beneficial interest. Non Resident Indians (NRIs) Currently there is a limit of 5 per cent for individual NRI portfolio investment with the aggregate limit for all NRIs restricted to 10 per cent but can be raised to 24 per cent with

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the approval of Board / General Body. This dispensation will continue. But, the policy guidelines of February 3, 2004 on acknowledgement for acquisition/transfer will be applied.

Due diligence process


The process of due diligence in all cases of shareholders and directors as above, will involve reference to the relevant regulator, revenue authorities, investigation agencies and independent credit reference agencies as considered appropriate.

Transition arrangements
i. The current minimum capital requirements for entry of new banks is Rs. 200 crore to be increased to Rs. 300 crore within three years of commencement of business. A few private sector banks which have been in existence before these capital requirements are prescribed are having less than Rs.200 crore net worth. In the interest of having sufficient minimum size for financial stability, all the existing private banks should also be able to fulfill the minimum net worth requirement of Rs. 300 crore required for new entry. Hence any bank falling below this level will be required to submit a time bound programme for capital augmentation to RBI for approval. ii. Where any existing shareholding of any individual entity/group of entities is 5 per cent and above, due diligence outlined in the February 3, 2004 guidelines will be undertaken to ensure fulfillment of fit and proper criteria. iii. Where any existing shareholding by any individual entity / group of related entities is in excess of 10 per cent, the bank will be required to indicate a time table for reduction of holding to the permissible level. iv. Any bank having shareholding in excess of 5 per cent in any other bank in India will be required to indicate a time bound plan for reduction in such investments to the permissible limit. The parent of any foreign bank having presence in India, having shareholding directly or indirectly through any other entity in the banking group in excess of 5% in any other bank in India will be similarly required to indicate a time

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CORPORATE GOVERNANCE IN BANKS bound plan for reduction of such holding to 5 per cent. v. Banks will be required to undertake due diligence of directors and Chairman / CEO on basis of criteria that will be separately indicated and provide all the necessary certifications/ information to RBI. vi. Banks having more than one member of family, close relative or associate on the Board will be required to ensure compliance with this requirement at the time of considering any induction or renewal of terms of such directors. vii. Action plans submitted by private sector banks outlining the milestones for compliance with the various requirements for ownership and governance will be examined by RBI for consideration and approval.

Continuous monitoring arrangements


i. Where RBI acknowledgment has already been obtained for transfer of shares of 5 per cent and above, it will be the banks responsibility to ensure continuing compliance of the fit and proper criteria and provide an annual certificate to the RBI of having undertaken such continuing due diligence, ii. Similar continuing due diligence on compliance with the fit and proper criteria for directors/CEO of the bank will have to be undertaken by the bank and certified to RBI annually, iii. RBI may, when considered necessary, undertake independent verification of fit and proper test conducted by banks through a process of due diligence as described in paragraph 8. 11. On the basis of such continuous monitoring, RBI will consider appropriate measures to enforce compliance.

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10. CORPORATE GOVERNANCE AND CO-OPERATIVE BANKS


Corporate governance has great relevance in the present environment. Co-Operative banks are supposed to run on ethical values to conduct their business and their success rest on the honesty and integrity of board members. To exercise proper control on their operations in order to safeguard deposits and other stakeholders interest, good corporate governance is the only alternative. The recent failure of a large number of banks has threatened the very survival of these banks. Therefore, there is an urgent need to restore the public faith in them, and for that matter proper disclosure norms and transparency in their working is the only alternative with proper control mechanisms from regulators and accountability of Board and senior management. The co-operative banks have different type of structure as compared to commercial banks. They are constituted on the co-operative principles of Voluntary Association, Self-help and Mutual Aid, One Share One Vote and Non- Discrimination and Equality of Members. Cooperative as a system arose out of reaction to the abuses of capitalists system based on free market economy. Co-operatives as a form pf business organization owes its origin to poverty and economic distress of weaker sections of the society. Their basic objectives is to help their members and as per co-operative principles only the members are allowed to borrow. The share of urban co-operative banks is around 7 per cent to 8 per cent only in comparison to total business of commercial banks, but still they occupy a significant position in the Indian banking sector. The majority of the urban banks are localized and their operations are limited to a single state or a district. A few of them are working in more than one state. They have a local feel and have contributed significantly to the well being of lower income groups of the urban and semi- urban people. They face certain regulatory problems because

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CORPORATE GOVERNANCE IN BANKS of duality of control and their unique structure.

11. CONCLUSION
Banks in India have in place a fairly robust framework for corporate governance in which modern practices of sound corporate governance can be incorporated and built up to further the interests of the individual banks and all the stakeholders. Thus, banks articulate corporate values, codes of conduct and standards of appropriate behaviour, etc., and have systems to ensure compliance with them. Banks also have well articulated corporate strategies decided by their boards. In pursuance thereof, performance budgeting system is followed, which measures, monitors and evaluates corporate success and the contribution of business units. Banks have clear delegation of powers to different levels of hierarchy for financial and non-financial sanctions. The mechanism for interaction and cooperation among the board of directors, senior management and the auditors is fairly established. Either on their own or under the guidance of RBI, most banks have put in place processes designed to monitor performance and fulfilment of duties and responsibilities at different levels. RBI checks the governance practices at banks and brings to the managements attention problems identified by it. It also emphasises accountability and transparency in banks, ensures that banks organisational structure provides for proper checks and balances, and proactively guides banks on sound corporate governance practices. The organisational structure of banks enables adequate oversight by their boards. The present system of control and audit in banks enables such oversight. Systems are in place which enable direct line supervision of different business areas. The directors do not interfere in day-to-day management of banks. While loans and advances to directors or to related individuals and bodies are prohibited by law, disclosure of interest by directors is mandatory. In case there is any likelihood of conflict of interest

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CORPORATE GOVERNANCE IN BANKS arising, the concerned director is required to abstain from participating in the decision making process relating to that case. The importance and independence of internal as well as external audit is well recognised and communicated throughout the bank. Audit in banks is seen as a function independent of operating departments and in most cases the head of audit reports directly to the Chairman/Board. External statutory auditors also present their report on the functioning of the bank to its Board directly. The Board meets the senior management and internal audit regularly and establishes and approves policies and monitors progress towards corporate objectives. There is an independent audit committee of the board and the appointment and removal of auditors by the boards of banks have to be with the prior approval of Reserve Bank of India. The process of induction of directors needs to be streamlined. Further, considering the complex challenges that banks are required to meet in the future, there would be need for directors who are conversant with risk management issues. In order to enhance effectiveness of boards, there would also need to be a ceiling on the number of boards that a director can be on at the same time. To increase the effectiveness of boards, there is need for separate committees for risk management, compensation and for nominations to the board. While boards need to set standards of accountability for themselves, there is also a need for enhanced transparency and disclosures in respect of various aspects of boards constitution and functioning. Sound corporate governance in Indian banks is hindered to some extent by the government/RBI ownership of banks. While, in the case of government ownership, the regulator may find it difficult to enforce urgent corrective action including removal of incompetent and, at times, corrupt management, in the case of RBI ownership, it leads to an overlap between its ownership and supervisory roles. There are no laws as such which can be seen as supporting or facilitating corporate governance and absence of such legislation is felt. However, as regulators, as the Reserve

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CORPORATE GOVERNANCE IN BANKS Bank of India and SEBI are gradually introducing measures which lead to good corporate governance in banks and protection of depositors and others interests.

ANNEXURE

Enhancing Corporate Governance for Banking Organizations

Principle

Indian Position

Remarks

A. Strategies and techniques basic to sound corporate governance 1. Corporate values, codes of conduct and other standards of appropriate behaviour and the system used to ensure compliance with them. Banks articulate corporate values, codes of conduct and standards of appropriate behaviour, etc., though these may not have been codified in any single document. Banks have also systems to ensure compliance with them. Within an overall generalised level, the depth and extent of compliance of the standards of corporate governance vary from bank to bank. It is, therefore, desirable that all banks are above a certain benchmark signifying acceptable level of corporate governance. From here, there will have to be a sustained progress towards the best international standards which would need to be

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achieved within a reasonable timeframe. Banks have well articulated 2. A well-articulated corporate corporate strategy decided by the Board of Directors. In strategy against which the success of the overall enterprise pursuance thereof, performance budgeting and the contribution of system is followed, which individuals can be measured. measures, monitors and evaluates corporate success and the contribution of business units. Except for performance measurement, monitoring and evaluation for business units, there is no system of accountability for results for individuals with the exception of the CEO, the Zonal / Regional / Branch Heads or Treasury Heads, etc. It is desirable that performance measurement, currently confined mostly to unit level, is extended downwards up to individuals and a linkage between contribution and remuneration/reward is established. It should be possible to do so easily if a consensus can be achieved between the unions and the management on converting the present flat and performance-unrelated remuneration structure prevalent in most banks into performance-related remuneration structure. A few banks in the private sector have taken a lead in this regard, but they are small and as of now represent a nominal percentage of banking business in the country.

3. Clear assignment of responsibilities and decisionmaking authorities, incorporating a hierarchy of required approvals from individuals to the board of directors. 4. Establishment of a mechanism for the interaction

Banks have clear delegation of powers to different levels of hierarchy for financial and non-financial sanctions.

The mechanism for interaction and cooperation

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and cooperation among the board of directors, senior management and the auditors.

among the board of directors, senior management and the auditors of the bank is fairly established. Banks definitely have a strong internal control system; internal and external audit functions and other checks and balances. However, the regulatory framework for risk management function in banks independent of business lines has recently been put in place. Banks are in different stages of implementation of risk management systems. It is practicable for big banks to undertake risk management as an independent function. However, small banks lack the expertise in this area. They will, therefore, have to be provided encouragement as well as technical support and given special attention so that they can imbibe risk management practices in as short a time as possible. A time-frame of two to three years is considered adequate for the purpose. A similar provision on the lines of Section 20 of the BR Act, 1949, will have to be made in respect of large shareholders too. A definition of large shareholding would, of course, need to be provided.

5. Strong internal control systems, including internal and external audit functions, risk management functions independent of business lines, and other checks and balances.

6. Special monitoring of risk exposures where conflicts of interest are likely to be particularly great, including business relationships with borrowers affiliated with the bank, large shareholders, senior management, or key decisionmakers within the firm (e.g., traders).

There is a statutory provision (Section 20 of the BR Act, 1949) prohibiting loans and advances to directors or to any firm or company in which directors are interested or individuals in respect of whom any of its directors is a partner or guarantor. However, where transactions are not barred by law, special monitoring of transactions with related parties, including large shareholders is not always subjected to special monitoring.

7. The financial and managerial There is no performanceincentives to act in an related compensation in

Please also see comments against A(2) above.

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appropriate manner offered to senior management, business line management and employees in the form of compensation, promotion and other recognition.

public sector banks and, therefore, there is very little incentive or disincentive for good or bad performance. Some private sector banks have made efforts towards performance related compensation. Managerial incentive in the form of promotion and other recognition prevalent in banks both in private and public sectors, has generally proved inadequate. Internal information flow is quite well established in banks. The standards of banks disclosures are improving but still fall short of international standards.

Unless performancerelated remuneration is introduced in public sector banks, which account for more than 80 per cent of Indian banking system, performance of the system is not expected to improve. All banks must be encouraged to take steps to adopt this approach without any further loss of time.

8. Appropriate information flows internally and to the public.

Please see remarks given in Annex 8.

B. Organisational Structure to ensure the following 'Forms of Oversight' 1. Oversight by Board of Directors. The organisational structure enables adequate oversight by Board of Directors. The present system of control and audit in banks enables such oversight.

2. Oversight by individuals not involved in the day-to-day running of the various business areas. 3. Direct line supervision of different business areas.

Systems are in place which enables direct line supervision of different business areas. A regulatory framework for risk management function in banks has recently been introduced. Banks are in

4. Independent risk management and audit functions.

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CORPORATE GOVERNANCE IN BANKS different stages of implementation of risk management systems. However, audit functions are well developed. The independence of audit function is described in C(3) (xi)(b) below. C. Sound Corporate Governance Practices Most banks follow a budgetary system. Strategic 1. Board to establish strategic objectives and a set of corporate objectives and set of values values (tone at the top') that are are often not defined very clearly and their communicated throughout the communication throughout banking organisation, timely the organisation is quite and frank discussion of uneven. Long-term problems problems and prohibit/limit conflict of interest, self-dealing and hindrances in the way of achieving organisational goals and related party transactions. tend to receive attention only at higher levels of management. Please also see comments at A(6) above. 2. Board to set and enforce clear lines of responsibility and accountability for themselves as well as the senior management and throughout the organisation so that there is no unspecified or confusing and multiple accountability and lines of responsibility. Boards of very few banks are known to enforce clear lines of responsibility and accountability for themselves. In quite a few cases there is not enough clarity about their roles. Much of it is because of the manner in which the boards are constituted. The lines for the responsibility and accountability for senior management and further down in the banks are, however, quite clearly defined leaving little room for unspecified or There is an urgent need to follow the best practices in banks in respect of constitution and functioning of the boards. The banks need to develop mechanisms which can help them ensure percolation of corporate strategic objectives and set values throughout the organisation. Please also see remarks at A(6) above.

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confusing and multiple accountability and lines of responsibility. 3. Ensuring that board members are qualified for their positions, have a clear understanding of their role in corporate governance and are not subject to undue influence from management or outside concerns: Selection for nomination of This practice can be put in individuals on banks boards place forthwith. is on the basis of his/her qualification considered suitable for the position. There is, however, no practice of pre-induction meeting/briefing or any postinduction orientation. As such, often a proper appreciation of their role in the banks corporate governance takes time to develop. Instances of undue influence from management or outside concerns are rare. There is a need to streamline the process of induction of directors into bank boards and their initial orientation. Suitable arrangement can be put in place forthwith.

i. understand their oversight role Boards of Directors and duty of loyalty to bank and sometimes take longer time shareholders. than expected to understand their role and obligation to the bank and the shareholders. New board members seldom go through any orientation programme. The boards generally serve as ii. serve as a 'check and balance' a 'check and balance' to the management. All members of to the management. the boards individually may not be said to be feeling and conducting themselves as ideally as envisaged.

The process can be selfsustaining once the responsibility and accountability are enforced.

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iii. feel empowered to question the management and insist on explanation from the management. iv. recommend sound practices gleaned from other situations.

Do

Do

v. provide dispassionate advice. Do vi. are not over extended. The system has till recently permitted board membership to an individual in up to 20 companies. This number is now sought to be reduced. Being on a number of boards does result in over-extension in some cases. Members of Board of Directors are required to give their valuable time to the governance of banks. In this context, there is a need to have some ceiling on the number of boards and the number of committees a director can work at a time. Relative SEBI guidelines limit membership of board/ Committees. Whereas in the case of listed companies this will hold good, the same principle may be adopted in the case of all banking companies.

vii. avoid conflict of interest in their activities with and commitments to other organisations.

The statutory provisions (Section 20 of the BR Act, 1949) prohibit loans and advances to directors or to any firm or company in which directors are interested or individuals in respect of whom any of its directors is a partner or guarantor.

Disclosure of interest by

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directors is mandatory and in case there is any likelihood of conflict of interest arising, the concerned director is required to abstain from participating in the decision making process relating to that case. viii. meet regularly with senior management and internal audit to establish and approve policies, and monitor progress towards corporate objectives. The board meets the senior management and internal audit regularly and establishes and approves policies and monitors progress towards corporate objectives. Yes.

ix. abstain from decision making when incapable of providing objective advice. x. do not participate in day-today management of the bank. xi. Form committees for:

Yes.

a. Risk Management Committee The regulatory guidelines for formation of Risk Management Committee are for a Committee of the Top Executives. Most banks are in a nascent stage of evolving risk management policies and practices. The present system of constituting an audit b. Independent Audit committee of the board Committee comprising of external members, oversight of chaired by one of the nonexecutive directors is able to internal and external auditors, their appointment and dismissal, ensure performance in these tasks satisfactorily. ensuring that management is taking appropriate action, etc.

Comprehensive risk management systems should be put in place in all banks at an early date. A timeframe of two to three years is considered adequate for the purpose.

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Appointment and removal of auditors by the boards of banks has to be with the prior approval of RBI. c. Compensation Committee oversight of remuneration of senior management, and other key personnel and ensuring compensation is consistent with banks culture, objectives, strategy and control environment. Public Sector Banks do not have Compensation Committees. The remuneration is fixed at the industry level uniformly for all banks at all levels of management with the approval of the Government of India. However, RBI approves the remuneration of CEOs of private sector banks. As of now, there is no Nomination Committee of the Board of Directors for nominating directors into the boards of banks, except in the case of some private sector banks. There is also no established system to assess the effectiveness of the functioning of the board members. The oversight is by Senior Managers who are not overly in the business and are knowledgeable. The oversight and checks and controls carried out by senior management may have no risk of losing an employee since the employment market is very tight. However, this may result in demotivation at the lower level. There is a need to review the current practice and link remuneration with performance.

d. Nomination Committee assessment of board effectiveness and directing the process of renewing and replacing board members

The desired change is possible after the ownership of the banks goes out of the governments fold. The present system of nomination of directors on the boards of banks is expendable.

4. Ensuring that there is appropriate oversight by senior management ('four eyes principle') senior managers not overly involved in business line decision making, are knowledgeable for their assigned area and willing to exercise control over successful and key employees without the fear of losing them.

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5. Effectively utilising the work conducted by internal and external auditors, in recognition of the important control function they provide recognising their importance and communicating this throughout the bank, enhance the independence and stature of auditors, utilising in a timely and effective manner their findings, ensuring their independence through the head auditor reporting to the board or boards audit committee, etc. 6. Ensuring that compensation approaches are consistent with the banks ethical values, objectives, strategy and control environment do not overly depend on short-term performance.

The importance and The position may be independence of internal as deemed satisfactory. well as external audit is well recognised and communicated throughout the bank. Audit in banks is seen as a function independent of operating departments and in most cases the head of audit reports directly to the Chairman/board. External statutory auditors also present their report on the functioning of the bank to its board directly. There is no performanceSee remarks against item related compensation in A(7) above public sector banks and therefore, there is very little incentive or disincentive for good or bad performance. Some private sector banks have made efforts towards performance-related compensation. Such cases, which are not many, are recent. However, it is difficult to say at this stage with any degree of certainty that these are always consistent with the control environment and is not overly dependent on shortterm performance.

7. Conducting corporate governance in a transparent manner Public disclosure is desirable in the following areas: i. Board structure (size, membership, qualifications and While the structure of the board is revealed in the This practice may be introduced.

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committees).

Balance Sheet, details of Committees and qualifications of the directors are not always available publicly. Indian banks may be encouraged to make this disclosure. Indian banks may be encouraged to make this disclosure. Indian banks may be encouraged to make this disclosure.

ii. Senior management structure This disclosure is not there. (responsibilities, reporting lines, qualifications and experience). iii. Basic organisational structure. This disclosure is not there.

iv. Information about incentive This disclosure is not there. structure (remuneration policies, executive compensation, bonuses, stock options). v. Nature and extent of transactions with affiliated and related parties: 1. Government through laws. Guidelines and norms for good corporate governance in banks and overall responsible corporate governance are still in formative stages and healthy conventions are still to be built up. There are no laws as such which can be seen as supporting or facilitating corporate governance. It will be some time before tenets of good governance can be enacted in a piece of legislation. The RBI as supervisor and SEBI as capital market regulator are gradually introducing measures which lead to good corporate

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governance in banks and protection of depositors and others interests. SEBI as the securities market regulator ensures healthy 2. Securities regulators, stock exchanges through disclosures growth of capital markets and stands for the protection of the and listing requirements. interest of shareholders. SEBI has stipulated disclosure and listing requirements and also reviews these on an ongoing basis. The ICAI sets the accounting standards for banks in 3. Auditors through audit standards on communications to consultation with RBI. boards of directors, senior management and supervisors. Standards on communication to Board of Directors, senior management and the Supervisors are, however, yet to be set and stabilise. 4. Banking industry associations through initiatives relating to voluntary industry principles and agreements on and publication of sound practices. Banks industry level associations like the IBA, FEDAI, FIMMDA, etc., are active in taking initiatives relating to voluntary industry principles and agreements.

E. Role of Supervisors 1. Board of directors and senior management are ultimately responsible for the performance of the bank. Supervisors typically check that a bank is being properly governed and bring to managements attention any problem that they detect The RBI as supervisor checks the governance practices at banks and brings to the managements attention the problems identified by them. Because of RBI/government ownership of banks in the public sector, there is some overlap in the role of the RBI as owner/owners representative and as the regulator/supervisor. This

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through their supervisory efforts.

overlap needs to be corrected so that RBI can perform its regulatory/ supervisory role without any hindrance. The RBI as supervisor, through on- and off-site supervision mechanisms, is attentive to warning signs of deterioration in management of a banks activities. Government ownership of banks, however, stands in the way of any serious and urgent corrective action on the part of RBI as regulator. Laws of the land and the implied delay in the judicial system have also come in the way even where corrective action like removal of a management not found to be 'fit and proper' was contemplated.

2. Attentive to any warning signs of deterioration in the management of the banks activities.

3. Issue guidance to banks on The RBI as supervisor issues sound corporate governance and proactive and timely guidance pro-active practices. to banks on sound corporate governance practices. 4. Sound corporate governance considers interest of all stakeholders, including depositors, whose interests the supervisors should protect. The basic spirit of banking supervision in India is to ensure that banks follow principles of sound banking and that the interests of all stakeholders, including depositors, are protected. The RBI as supervisor ensures that banks have organisational structure to ensure proper checks and balances. The standards of transparency would need

5. Should expect banks to implement organisational structure to ensure checks and balances.

6. Emphasise accountability and The RBI as supervisor

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CORPORATE GOVERNANCE IN BANKS to be raised. A fair emphasises accountability and beginning has been made in this regard but the transparency in banks. approach of the banks and the applicable accounting standards will have to be changed for achieving greater transparency in banking operations and accounting. The stress on accountability largely ends up with efforts to fix accountability for loans/advances that go bad. Accountability for non-performance, at any level including that of the Board of Directors, is nearly absent. This issue needs urgent attention. 7. Determine that board and senior management have in place processes that ensure they are fulfilling all of their duties and responsibilities. Either on their own or under the guidance of the RBI as supervisor, most banks have put in place processes designed to monitor performance and fulfilment of duties and responsibilities at different levels. The boards of banks, however, do not seem to subject themselves to any measure of accountability or performance either set by them voluntarily or made applicable to them externally. This leaves them as largely without any accountability either to the institution itself or to the supervisor. The situation calls for correction.

transparency.

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Bibliography
www.rbi.org www.google.com www.iba.org www.hdfc.com

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