Corporate Governance in the Banking System 01/04/2017 Corporate Governance in the Banking System Third Pan-African Consultative Forum on Corporate Governance Dakar, Senegal 9 November 2005 Kirk Odegard Secretariat, Basel Committee on Banking Supervision

Sound corporate governance principles The role of supervisors 01/04/2017 Outline Background Sound corporate governance principles The role of supervisors Unique challenges Conclusions

01/04/2017 Background

01/04/2017 Background Organisation for Economic Co-operation and Development (OECD) is international standard-setter for corporate governance OECD issued corporate governance principles in 1999 Basel Committee issued guidance in 1999 applying OECD principles to banks Late 1990s/early 2000s: corporate scandals OECD issued revised principles in 2004 Basel Committee currently reviewing bank guidance

Why guidance for banks? Critical role in the economy 01/04/2017 Why guidance for banks? Critical role in the economy Need to safeguard depositors’ funds Importance of trust and confidence High cost of bank failures Sensitivity to liquidity crises Access to confidential customer information Increasing complexity of bank activities

Foundations of effective governance 01/04/2017 Foundations of effective governance Foundations of effective corporate governance are important but may be beyond supervisory control: Macro-economic policies System of business laws Market integrity and transparency Accounting standards Banking supervisors should be aware of impediments to sound corporate governance and take steps within their power to promote effective foundations 1st paper concordat: confidential Last on website: compliance and the compliance function in banks Most often downloaded paper from BIS website

Everyone’s responsibility 01/04/2017 Everyone’s responsibility Board and senior management are primarily responsible for effective corporate governance Others can help promote sound bank governance: Shareholders Auditors Industry associations Governments Banking supervisors Stock exchanges and securities regulators Employees 1st paper concordat: confidential Last on website: compliance and the compliance function in banks Most often downloaded paper from BIS website

Sound corporate governance principles 01/04/2017 Sound corporate governance principles

Working Group on Corporate Governance 01/04/2017 Working Group on Corporate Governance Established by Basel Committee to review guidance Incorporated elements of 2004 OECD principles Discussed lessons learned from corporate governance breakdowns Met with industry groups and rating agencies Consulted with non-BCBS supervisors Issued consultative paper in July 2005 Final paper expected late 2005/early 2006 1st paper concordat: confidential Last on website: compliance and the compliance function in banks Most often downloaded paper from BIS website

July 2005 consultative paper  May be revised based on consultation  01/04/2017 July 2005 consultative paper Apply to a wide range of banks and countries Applicable to diverse corporate and board structures Principles, not rules Not as prescriptive as some national legislation Commensurate with bank size, complexity and risk profile Not part of Basel II  May be revised based on consultation  1st paper concordat: confidential Last on website: compliance and the compliance function in banks Most often downloaded paper from BIS website

2004 vs. 1999 guidance Introduction of “know your structure” guidance 01/04/2017 2004 vs. 1999 guidance Introduction of “know your structure” guidance Expanded to consider group structures Protection for “whistleblowers” State-owned and other non-listed banks More in-depth discussion of: Conflicts of interest Role of the board of directors Audit and other control functions Role of banking supervisors

Sound corporate governance principles 01/04/2017 Sound corporate governance principles Strategic objectives and corporate values Clear lines of responsibility and accountability Role of board of directors Oversight by senior management Internal and external auditors and other control functions Compensation policies and practices Governing in a transparent manner “Know your structure”

01/04/2017 Establishing strategic objectives and a set of corporate values that are communicated throughout the banking organisation.

Strategic objectives and corporate values 01/04/2017 Strategic objectives and corporate values Should be established by the board of directors Corporate culture should foster ethical behaviour “Tone at the top” is important Standards should address corruption, self-dealing and other unethical or illegal behaviour “Whistleblowers”: Employees should be encouraged to raise concerns about illegal or unethical practices to the board or an independent committee without fear of reprisal Basel II is less a compliance exercise than an opportunity to upgrade risk management systems

Potential trouble situations 01/04/2017 Potential trouble situations Lending to officers, employees or directors where allowed by national law Consistent with market terms or terms offered to all employees Limited to certain types of loans Reports should be provided to the board Subject to review by auditors and supervisors Preferential treatment to related parties Conflicts of interest Basel II is less a compliance exercise than an opportunity to upgrade risk management systems

Addressing conflicts of interest 01/04/2017 Addressing conflicts of interest Potential conflicts of interest arising from activities of the bank should be: Identified Prevented or appropriately managed Information barriers between different units Separate reporting lines and internal controls Clear, fair, accurate information to customers Appropriately disclosed Basel II is less a compliance exercise than an opportunity to upgrade risk management systems

01/04/2017 Setting and enforcing clear lines of responsibility and accountability throughout the organisation.

Board and senior management 01/04/2017 Board and senior management Unclear lines of responsibility can make problems worse The board of directors should: Define authorities and key responsibilities Oversee management actions Senior management should: Delegate responsibilities to staff and promote accountability Be responsible to the board for the performance of the bank

Accountability within banking groups 01/04/2017 Accountability within banking groups Parent board and senior management: Set general strategies and policies for the group Determining governance structure for subsidiaries that best contributes to effective oversight Be aware of risks throughout the group Integrate and coordinate governance structures Bank board and senior management: Responsible for governance of bank Soundness of bank, protection of depositors, compliance with laws and regulations Intra-group outsourcing (e.g. internal audit, risk management) do not eliminate bank board oversight Has ultimate responsibility for corrective action at the bank

01/04/2017 Ensuring that board members are qualified for their positions, have a clear understanding of their role in corporate governance and are able to exercise sound independent judgment about the affairs of the bank.

01/04/2017 The board should… Understand oversight role and duties to bank and shareholders Avoid conflicts of interest Have sufficient time and energy to fulfill responsibilities Maintain collective expertise as bank grows Implement targeted board training as necessary Assess the effectiveness of its own governance practices Ensure bank has an appropriate plan for executive succession Question and receive information from senior management Provide sound and objective advice Do not participate in day-to-day management Exercise due diligence in hiring external auditors

Independent directors 01/04/2017 Independent directors Board should have adequate number of independent directors Independence = ability to exercise objective judgment Helpful if not members of bank management Especially important in certain areas: Ensuring integrity of reporting Review of related-party transactions Nomination of board members and key executives Board and key executive compensation

Ensuring that there is appropriate oversight by senior management. 01/04/2017 Ensuring that there is appropriate oversight by senior management.

Senior management responsibilities Should have necessary skills to manage business and exercise appropriate control Oversee line managers consistent with board policies Critical role: Establishing system of internal controls Situations to avoid: Inappropriate involvement in business line decisions Managing areas without skills or knowledge Inability to control “star” employees

01/04/2017 Effectively utilising the work conducted by internal and external auditors, as well as other control functions, in recognition of their critical contribution to sound corporate governance.

Auditors and other control functions Should be: Independent Competent Qualified Identify problems in risk management & internal control Ensure financial statements are accurate

Enhancing audit & control effectiveness Recognise importance and promote throughout bank Enhance independence (e.g., limit non-audit services) Auditors have duties to bank and its stakeholders Consider rotation of audit firm or lead audit partner Utilise audit findings and require timely correction Report to the board or audit committee External auditors review internal controls Independent directors meet in the absence of bank management with external auditor and heads of internal audit, compliance, legal functions

01/04/2017 Ensuring that compensation policies and practices are consistent with the bank’s ethical values, objectives, strategy and control environment.

Board and key executive compensation Compensation should be consistent with: Long-term business objectives and strategy Corporate culture Control environment Should not overly depend on short-term performance Board (or independent committee) should approve compensation Policies re: trading bank stock and granting/re-pricing stock options

Conducting corporate governance in a transparent manner. 01/04/2017 Conducting corporate governance in a transparent manner.

Transparent governance Necessary for shareholders, other stakeholders and market participants to monitor and hold accountable the board and senior management Need information on corporate structure and objectives Complex cross-shareholdings can impede transparency At a minimum, all banks should make disclosures to supervisors

What should be disclosed? Disclosure on public website or in annual report: Board and senior management structure Organisational structure (including ownership) Incentive structure of the bank Code of business conduct and/or ethics Related-party transactions Full annual financial statement with supporting notes and schedules

01/04/2017 Maintaining an understanding of the bank’s operational structure, including operating in jurisdictions, or through structures, that impede transparency (i.e. “know your structure”).

Operational structure Some bank operations may lack or impair transparency Particular jurisdictions (e.g. some offshore centres) Complex structures (e.g. special purpose vehicles or corporate trusts) Banks may provide services or establish opaque structures for clients Often legitimate and appropriate business purposes

Supervisory concerns The use or sale of opaque structures/products may: Pose potentially significant financial, legal and reputational risks Impede board and senior management oversight Hinder effective banking supervision Risks should be appropriately assessed and managed

Risk management expectations Clear policies and procedures should be in place Approval for use and sale Identify and manage all material risks Need for such activities should be regularly assessed Corporate governance expectations should be established for all relevant entities Activities should be subject to enhanced audit procedures and internal control reviews Assess compliance with applicable laws, regulations and internal policies and procedures

The role of supervisors 01/04/2017 The role of supervisors

01/04/2017 Supervisory role Poor corporate governance practices can be a cause or a symptom of larger problems Banking supervisors should: Promote strong corporate governance Determine whether the bank has sound corporate governance policies and practices Hold the board of directors and senior management accountable for governance and internal control weaknesses Be attentive to warning signs of deterioration in management Consider issuing supervisory guidance for governance

Supervisory questions 01/04/2017 Supervisory questions Does the board exercise effective oversight? Are controls to detect and mitigate conflicts of interest adequate? Are internal controls properly implemented (as opposed to being written down but not operational)? Do internal and external audit functions conduct independent and effective reviews? Are major shareholders, directors and managers “fit and proper”? Will an individual’s skills and experience contribute to bank safety and soundness? Does criminal or regulatory record make a person unfit? Is a group structure managed in such a way as to negatively impact management of the bank?

01/04/2017 Unique challenges

Controlling shareholders 01/04/2017 Controlling shareholders For example, family-owned or other non-listed banks Controlling shareholders can be a valuable resource Unique governance challenge because of influence There should be sufficient checks and balances on inappropriate activities or influences The board and its directors have responsibility to the company and all of its shareholders Supervisors should be able to assess fitness & propriety of bank owners

State-owned banks OECD has issued guidance for state-owned enterprises 01/04/2017 State-owned banks OECD has issued guidance for state-owned enterprises General principles should be applied to state-owned banks Ownership and supervision functions should be fully separated Government should not be involved in day-to-day management Board independence from political influence should be respected Objectives of state ownership and state’s ownership policy should be disclosed

01/04/2017 Two-tier boards Some countries adopt a two-tier board of directors (e.g. management board and supervisory board) Basel Committee recognises that both one-tier and two-tier boards may be appropriate Two-tier boards may be structured differently across jurisdictions, so no specific guidance Whichever structure is used, principles of sound corporate governance should be in place

01/04/2017 Conclusions

Wrapping up Banks have a unique role in the economy, so targeted corporate governance guidance is appropriate Key elements: Board of directors = oversight Senior management = internal controls Supervisors = promote and assess sound governance Actual practice is just as important as written policies and procedures

Questions or Comments? Kirk Odegard Member of Secretariat 01/04/2017 Questions or Comments? Kirk Odegard Member of Secretariat Basel Committee on Banking Supervision Bank for International Settlements kirk.odegard@bis.org