1. ©2000 Bank for International Settlements 1 F I N A N C I A L S T A B I L I T Y I N S T I T U T E BANK FOR INTERNATIONAL SETTLEMENTS Some Thoughts on Corporate Governance in Financial Institutions 3rd Annual International Seminar for Central Bank Deputy Governors Washington DC, 4-6 June 2003 Josef Tošovský Chairman Financial Stability Institute

2. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 2 Contents I.Addressing weaknesses in market foundations II.Some issues of corporate governance in financial institutions

3. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 3 I. Addressing weaknesses in market foundations 1.Why is corporate governance such a hot topic? Enron Allied Irish Bank WorldCom Ahold

4. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 4 2.Global concerns Weaknesses in market foundations are not an isolated US problem Weaker institutional framework in emerging economies makes it easier to adopt bad practices and more difficult to get rid of them

5. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 5 3.What has contributed to these problems? Financial institutions have become larger: Shareholder control has diminished –Ownership more dispersed –Majority of corporate share ownership is for investment not for operating control of a company –Few shareholders have sufficient stakes to influence the choice of board of directors and CEOs Financial institutions have become more complex –More difficult for board members to monitor risk profile of the institution And more…

6. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 6 4.Weaknesses in internal safeguards Board and management oversight Internal controls Internal audit

7. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 7 5.Weaknesses in external safeguards Accountancy External audit Regulation and supervision Rating agencies

8. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 8 6.Why did both internal and external safeguards fail simultaneously? Liberalisation, deregulation, growth of financial markets and financial institutions was not accompanied by adequate institutional framework strengthening Economic cycle – bad loans are made in good times; similar can be valid for corporate governance – bad decisions are made during good times

9. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 9 7.Broad register of issues Corporate governance (including compensation schemes) Auditors oversight, independence and standards Accounting standards Credit rating agencies Market based system has worked very well for many years. Balanced approach addressing weaknesses necessary – danger of overreaction.

10. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 10 II. Some issues of corporate governance in financial institutions 1.Definitions OECD principles of corporate governance “Corporate governance relates to the internal means by which corporations are operated and controlled” Cadbury Report, 1992 “Corporate governance is the system by which companies are directed and controlled”

11. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 11 2.Importance of corporate governance in financial institutions Not only for well-being of an individual company and its stakeholders but because corporate governance: –Promotes effective allocation of the nation’s savings –Essential for financial stability –Important for long-term performance of the economy

12. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 12 3.Specific reasons for sound corporate governance in financial institutions Reliance on debt funding and the confidence of creditors Opaqueness and complexity of the risks of financial institutions

13. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 13 4.Key players Systemic –Legal and regulatory authorities –Supervisory authorities Institutional –Shareholders –Board of directors –Executive management –Audit committee/internal audit –External audit

14. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 14 4.Key players (continued) Public/consumer –Investors/depositors –Rating agencies –Analysts –Media International Organisations –OECD –The IMF and World Bank –Basel Committee on Banking Supervision –The Joint Forum

15. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 15 5.What is happening now? Worldwide discussion on corporate governance Reduced significance of national/domestic legislation Tendency towards harmonisation and benchmarking Creation of international best corporate governance standards

16. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 16 Conclusions Public concern caused by recent scandals has been a potent driver of improved governance practices Public scrutiny of company/board practices has risen markedly Desire to avoid reputation/legal risk should provide an ongoing incentive

17. 1 BANK FOR INTERNATIONAL SETTLEMENTS ©2001 Bank for International Settlements F I N A N C I A L S T A B I L I T Y I N S T I T U T E 17 Character, attitude and integrity of top representative determine good corporate governance.