BACKGROUND & IMPORTANCE:

1.1 The finance sector has assumed a special place in all economies due to increasing integration of markets, sophistication of financial products and intermediations particularly feeding on the dramatic developments in the “info way”. Its importance has also been heightened due to the perceived potential of the carnage of the kind noticed in the Asian region, and more recently in Argentina, Russia, and Turkey and capital markets worldwide.

1.2 Applying the reasoning of Coase in the case of firms, the existence and development of financial markets is primarily to reduce the information cost of borrowing and lending and thus lower transaction costs. The potential for such intermediation has been growing with the changing needs, widening consumption patterns and sophistication of products and services that are fueled by an exponential growth in knowledge and financial flows. In the process, the financial sector has assumed the same critical importance as that of the circulatory systems in a human being.

1.3 The financial system provides the platform to facilitate exchange of goods and services, mobilize savings, give credit, and monitor them. The system ensures that risks are pooled and shifted in favor of those who can bear it on a continuous basis, providing alternative investments and intermediating to overcome informational asymmetries. In an ideal sense, when the circulatory system is functioning well, it should reach all parts of the economy effectively, efficiently, and equitably. A well-developed financial system would not impair any section of the society but would, in fact, contribute to economic growth as well as poverty reduction. This, despite the current perceptions of growing inequalities concurrently with growth. As Amartya Sen has commented “The availability and the access to finance can be a crucial influence on the economic entitlements that economic agents are practically able to secure. This applies all the way from large enterprises¼¼to tiny establishments that rely on micro credit” (as quoted in WDR-2002).

1.4 NBFIs, within the financial system, cover a wide variety of organizations such as deposit taking companies, cooperative banks, insurance companies, development financial institutions, “chit funds”, credit societies, mutual funds, venture capital firms and other service providers1. These cater to a range of requirements such as payments services, liquidity, divisibility, maturity transformation, store of value, information economics, risk pooling etc. In the South Asian region major financial institutions are mainly the products of a macro-planning process. It is probable that the financial system in most developing countries is still dominated by banks and the State sponsored development finance institutions, since it is mostly during the 90s that a transition was initiated for actively developing the capital markets, which was the main trigger for the growth in financial sophistication.

1.5 Though the NBFI sector has played a relatively smaller role in many of the developing countries, there is a growing realization of the close connectivity between economic development and the size and sophistication of the NBFI sector. Research appears to indicate that this sector needs particular attention from the policy makers, regulators, as well as the market players to ensure that the right set of incentives and policy signals are transmitted to enable robust growth in financial intermediaries. The economic rationale has been supported by a few studies that not only conclude that economic growth and growth of financial intermediaries co-exist but find a causal relationship, to suggest that the growth in the NBFI sector could lead to economic development. For instance, a study (Levine, Loaya and Beck, 1999) estimated that if Argentina had experienced the world average growth in financial intermediaries during 1960-95, it would have achieved about one percentage point faster real per capita GDP growth per annum. The study also revealed in the case of India that if the NBFIs had raised their percentage of finance to the private sector (which was relatively low) to the average for developing countries, it would have benefited by an accelerated growth in real per capital GDP of about 0.6 percentage points per year.

1.6 The special case for NBFIs arises from the belief that they achieve a depth and diversity that normally eludes the banking system. It is possible for banks to provide several types of services but there could be constraints of strategic choices, transaction costs, opportunity costs, conflicts of incentives, and the attendant issues of quality and efficiency. Consequently, NBFIs can supplement and complement the banking system through appropriate strategies by offering unique and efficient financial services that can stimulate private sector growth as well as development among the rural and disadvantaged segments. They have particular informational advantages and proactiveness that may be difficult to achieve for many banks. They also provide the essential spirit of competition in the financial sector that again has been less apparent in Bank-based systems in the developing countries. Most importantly, Alan Greenspan had drawn the attention of the world to the importance of backup facilities in the financial system to be able to absorb shocks and spread risk. He aptly referred to the need for a spare tire in the financial system and attributed the lack of it as a major cause for the severity of the Asian Economic crisis. This spare tire may be required by several emerging markets that are yet to discover the impact of kinks in the global financial architecture. Either for economic growth or for averting systemic risks, a robust and growing NBFI sector is an imperative.

CRITICAL CG ISSUES:

2.1 The critical CG issues in this sector are probably related to (a) macro policy/ structure (b) board level governance in general and (c) governance specific to organisational forms such as credit unions, urban cooperative banks, developmental financial institutions, insurance, mutual funds, venture capital companies, lease finance companies and building societies.

Macro Issues:

2.2 The key issue that creates the climate for appropriate corporate governance is the legal framework and the policy signals transmitted by the parliament/legislature and the ministries concerned. Legal framework includes the kind of powers vested with the regulators and the quality of independence that is allowed by the policy makers in power. Laws and rules regarding accounting, property rights, and contract enforcement have been particularly found to be important for financial development. In many countries, the legal framework has not kept pace with the developments in the information technology and financial products and services. Consequently, there is scope for inappropriate incentives and exploitation of gaps in definitions of instruments such as securities, deposits, insurance, mortgages, leases, options, sweat equity, venture capital, etc. Concurrently, the levels of control exercised by the elected bodies/individuals in directing or even “managing” the regulatory mechanisms are also of concern in developing the climate for effective corporate governance. Excessive intrusions are the main source of conditions for moral hazards.

2.3 In addition, the level of skills and knowledge in the economy to support the sophistication in the sector has also been found to be an important macro issue that would instill good corporate governance practices. Sufficient number of bankers, accountants, lawyers, actuaries, and insolvency experts have been recognized as an invaluable resource to set the climate for good corporate governance. An emerging concern is the lack of sufficient knowledge, skill, and competency amongst board directors and their availability in sufficient numbers. The number of qualified directors is an important factor that could determine the quality of corporate governance in the country. As the overall intensity and magnitude of skills developed in a country are the result of macro policy initiatives, the production of sufficient number of trained and competent board directors should be in the direct agenda of the policy makers.

2.4 Regulation is obviously an important factor that determines the conditions for corporate governance and the growth and robustness of the NBFI sector. There are two main issues of relevance here. Firstly, the structure of the regulation and secondly, the quality of such regulation. The structure of regulation involves how synergetic various regulatory bodies are and whether they overlap and create incentives for regulatory gaps and arbitrage. The more synergetic the regulatory wings are, the less will be the scope for various players in the NBFI sector to circumvent and attract systemic risks. The massive growth of deposit taking NBFIs and cooperative banks in some of the countries and their subsequent failures have been recognized as the direct outcome of poorly designed regulation that stimulated adventurism. The regulatory structure also includes the quality of independence that they can enjoy. As Already mentioned, intrusion into regulatory authority can provide incentives for moral hazard to grow, through directed bail-outs, restructuring, takeovers, and the like.

2.5 The quality of regulation is of relevance to ensure that it is not repressive and that it recognizes the overall developments in the sector and the dynamics and complexities of prudential norms and risk management. The quality of regulators and their own knowledge and competence are of particular relevance in this context as there are no conditions for contestability for this institution. The quality of regulation will be reflected in the rules, guidelines, inspection and monitoring exercised. It reflects in establishing norms and implementing the same in a dynamic manner such as those pertaining to licensing; ownership restrictions; capital requirements; anti-collusion rules; disclosure; market conduct rules; governance and fiduciary duties; balance sheet restrictions; associations among financial activities/institutions; liquidity requirements; accountability requirements; compliance mechanism; off-site monitoring; inspections; preemptive resolutions; support schemes; penalties and prosecution.

2.6 The quality of informational infrastructure (such as accounting standards, quality and independence of auditors, reporting standards, transfer pricing and valuation of assets) and market infrastructure (state ownership, competition policy etc) are also of importance in providing the climate for promoting corporate governance. Needless to state, conducive quality of macro environment would be the outcome of good governance that is founded, inter alia, on principles of democracy, welfare, transparency and accountability.

Board Level Governance:

2.7 The norms regarding board structures, systems, and processes have been well captured in the OECD and CACG guidelines. These have created a veritable value system against which board structures, systems, and processes are being reviewed worldwide. These principles will be of particular relevance to those NBFIs which are companies, especially the publicly traded. Acknowledgedly, some of the principles might be of relevance to other entities such as cooperatives, societies and trusts.

2.8 The OECD principles as also the CACG guidelines emphasize the criticality of the Board in corporate governance - its composition, leadership, integrity and independence. Understandably, international investing community gives primary importance to shareholder rights, their equitable treatment and evidence to show that the dominant shareholder is not the beneficiary of better information, insider trading and connected lending.

2.9 The deposit taking non-banking finance companies, as in India, have collapsed in hundreds in a short period and there is a virtual stagnation in this segment. Companies in this segment need to reform their boards and corporate governance processes to revive public confidence, gather financial resources and grow their businesses. Even as the regulatory systems and legal back up need reform, the initiative for revival of this segment lies mostly in the hands of the NBFIs themselves. They can do so by respecting shareholder and financial stakeholders rights (including depositors); meeting international standards in accounting and disclosures and Board restructuring to make them active and independent.

2.10 It may be worthwhile for such companies to revisit the personal values of the dominant shareholders and reposition the operating corporate mission that will assure long-term viability and better relationship with all stakeholders. (Refer Criteria 1, 9 of OECD working kit and Principles 1,3 and 8 of CACG). They may start encouraging debate and challenge, in the boards and the general meetings, as a necessary input to making better choices. These companies need to respect the rights of all shareholders and stakeholders for equitable treatment in access to information. (see OECD principles and Principles 6.7.9 of CACG). Reform of the Board and its processes are well within the ambit of those in control and requires only wisdom and initiative.

2.11 Disclosures of ownership structure, the people behind, the connectivities, the safety/fire walls etc., build public confidence. The most critical problem of such NBFIs (as also the Urban cooperative Banks in India) has been the extent of connected lending leading to unsustainable risk, asset-liability mismatches and liquidity crises. Measures must be evident as to how this scourge is being addressed by the company not merely through statements of compliance but by an activist policy. Accounting practices and the quality of auditing have been in greater doubt with the recent happenings in the corporate world. Here again, there has been a noticeable pattern of “technical mismanagement” (poor appraisals, poor risk portfolio, unsustainable rates of interest on deposits, indecent compensations etc) leading to “cosmetic management” (showing fictitious income/receivables, ever-greening of NPAs) leading to desperate management (quick fixing by collusion with suppliers, clients, auditors) eventually leading to “fraud” (outsight criminality). Progressive companies have been trying to impress the reputation agents (research analysts, media, rating agencies) and the public by reaching international standards of accounting, reporting, disclosures and social responsibility that go beyond the statutory minimal. NBFIs may find such a move worthwhile to be able to raise resources, grow and sustain (CACG principles 5,7,10,15).

2.12 Corporate Governance principles demand that Boards be truly independent and that each member must owe his first duty to the company, the artificial person. Not to the dominant shareholder, the CEO or the powers recommending appointment. Boards lose their relevance as a mechanism to fix the agency problem, if they are replete with and dominated by executive directors and promoter directors. Independence arises through a sufficient number of thinking, guiding, complementing and inspiring directors who are truly independent and add value to the strategy of the company, selected through an objective and transparent process. Periodic evaluation of Boards and the members along with well-designed compensation systems will support their quality and independence. Such reform entails a shift in the locus of control - from the management or the dominant shareholder to the board. Concurrently, the quality of Board meetings would need a reform so as to set a vision, think strategically, monitor risks constantly and, inspire strategic management. (4,6,7 of OECD working kit and CACG principles 1,2,4,9,11,12,14 and 15.)

Segmental issues:

3.1 While the above aspects of corporate governance are not controversial in themselves, their specific usefulness for some of the NBFIs should be reviewed closely. In the developing world, the legal framework such as those relating to credit unions/cooperative banks or the insurance companies or mutual funds may not fully allow or mandate sufficient board independence, disclosures, restrictions on conflict of interest, and adequate participation of the important stakeholders/members. Consequently, in applying the corporate governance template to some of the specialized organizational forms in the NBFI, a vertical reform may be called for. Such a reform must reckon the governance and prudential/risk propositions of the particular organizational form and the laws as well as market conditions surrounding them. The report and recommendations emanating from the United States regarding the directors on the trust/companies of funds is of particular relevance in this context.

3.2 Similarly, the credit unions (or various types of cooperative banks) must follow the principles of cooperative movement which include voluntary and open membership; democratic member control; member economic participation; autonomy and independence; education, training, and information; cooperation among cooperatives and concern for community. The cooperative identity centres around the common bond, self-responsibility, and a great tradition that supports transparency, integrity, and accountability. A well functioning cooperative will rely on mutuality than periodic bail-outs, write-off, and unjustified subsidies.

3.3 Improving the standard of governance of such entities must be clearly rooted and aligned with the cooperative principles, and call for appropriate changes in law governing such entities to enable board independence; elimination/restriction on connected lending; separate disclosure mechanisms to the members; ensuring members’ active participation; devoted regulation and the like. Role models in such cooperatives obviously follow a set of best practices that make them sound, growing and sustainable. A study of such best practices would probably indicate some special features that need to be adopted by the segment in Board structures and processes, restrictions on connected lending, members’ involvement, risk management, reporting and disclosures.

3.4 In addition, credit unions/cooperative banks are probably best suited to initiate actions to develop self-regulatory organizations (SRO) that can generate adequate supplementary information and support to the regulatory system (It is possible for the federal bodies sponsor such SROs or even transform themselves into one such). The SRO would be well positioned to develop best practices and norms applicable to this segment and also undertake independent rating mechanisms. The SRO may even be able to create funds for mutual bailouts, initiate mergers where required and alert regulators independently of potential collapses that could result in a cotangion. (The deposit taking NBFIs and the urban cooperative banks in India have found that the depositors’ confidence was totally eroded due to mismanagement and fraud of some of these entities. Consequently, these segments are examining in consultation with the Academy of Corporate Governance, the desirability of setting up SROs to bring back investor confidence and regulating their own members by insisting on best practices.)

3.5 Such SROs would also be in a position to supplement governmental and regulatory initiatives in capacity building and progressing towards conformity with the recommendations of the Financial Action Task Force (particularly Recommendations 10-29 of the 40 Recommendations pertaining to NBFIs).

CONCLUSION:

4.1 In conclusion, it is apparent that the NBFI sector is too important to be left behind in the mainstream of attention to enhancing the standards of corporate governance. The sector has an intimate connection with economic development as well as for averting potential systemic risk. For improving corporate governance standards in various segments in this sector, one must probably differentiate between entities which are companies and those which have other organizational forms and laws. The need for a special attention will become apparent when one examines the credit unions/cooperative banks which have to be rooted in the principles of cooperative movement and the Trust, relevant to mutual funds and venture capital. In doing so, there is an obvious requirement to reform vertically the legal and regulatory framework governing them and ensuring that they are in alignment with the preferred macro environment and corporate governance practices specially required for those organizational forms.

4.2 At the same time, the generic requirements continue to be relevant. These requirements pertain to creating a macro environment that supports information infrastructure, market infrastructure, a regulatory regime that does not give scope for inappropriate incentives and signals; and a legal framework that assures the stake-holders of good accounting standards, property rights, and contracts enforcement. Concurrently, the OECD and CACG principles are imperative for companies within the NBFI sector and several of them are also of inspirational value in devising focused codes, principles and best practices for other organisational forms.