Academy of Corporate Governance the Website for CG with India focus

Financial System and Economic Development

1.0 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” as also 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.

1.1 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 reduce transaction cost. The potential for such intermediation has been growing with the changing needs, consumption patterns and sophistication of products and services that are fueled by an exponential growth in the 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 (as opposed to those of a dinosaur).

1.2 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 does 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.

1.3 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 enterprises……to tiny establishments that rely on micro credit” (as quoted in WDR-2002). There is growing evidence to show that development of the financial system and its sophistication not merely coexists with economic growth but may actually be causing it. There is also some evidence to show, contrary to the popular perception, that in some societies the income distribution could improve.

1.4 Financial sector comprises of several institutions that perform the functions of intermediation and reduction of risks, information asymmetry and eventually the transaction cost. Financial institutions comprise banks, development financial institutions, chit funds, credit societies, service providers, mutual funds, venture capital firms, insurance, deposit taking non-banking firms etc. 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. The financial system in most developing countries is still dominated by banks, since it is mostly during the 90s that a transition was initiated for actively developing the capital markets.

1.5 The non-banking financial institutions are fairly small as a proportion of GDP as well as a % of aggregate bank deposits (In the case of India it is about 0.87% of GDP and 2.2% of aggregate bank deposits, in respect of the registered NBFCs). It is also evident that there is a high degree of concentration within NBFCs. (In the case of India, nine companies account for 57 per cent of the total deposits and the top 75 out of 1005 companies account for 93%). The insurance sector also is in the process of development with relatively lower levels of demographic penetration (about 20% of insurable population for life business in India) and contributing to a small percentage of GDP (for instance, life insurance premia is under 1.5% of GDP compared to 6-7% in the UK).

1.6 As mentioned, though capital markets have existed for decades, their liberalization and development has been recent. Consequently, market capitalization as a proportion of GDP also is relatively small (value traded as a % of GDP in the case of India is 4.8% against 38.3% in Japan, 34.4% in US and 20.3% in Thailand)

1.7 There is evidence to show that the corporate sector depends more on debt and internal resources than external equity in most of the developing countries. Of the new capital for corporate growth, equity accounts for a fairly small portion (about 11% in India in the peak 90s) and the market for corporate debt is being used by only a limited number of big corporates. This probably does not indicate the irrelevance of capital markets as much as the potential of foregone opportunities in unlocking the equity culture and potential which could have contributed to the overall sophistication and depth of the financial system.

1.8 As the capital markets grow the stock exchange regulators have a critical duty to promote corporate governance. The stock exchange regulator would ensure that the shareholder rights are being protected, that there is equitable treatment among shareholders; that the management, dominant share holders and intermediaries are transparent and do not benefit from special privileges of information and market manipulation; that investors grievances are being redressed; that the overall framework of trading in equities evokes investor confidence, both domestic as well as international. The stock exchange regulator probably uses the tests of growing investor confidence, growth in trading volumes and absence of scams as the proof of keeping this fragile system going. In the process, the stock exchange regulator relies upon both the powers it has under the law to penalize errant companies and financial intermediaries and also on a host of self-regulating organizations predominant of whom are the Stock Exchanges.

1.9 For historical and transition reasons the financial system continues to have the domination of Banking and the Development Financial Institutions both of which are again dominantly owned by the State in some of the developing countries. State ownership of banks have been a particular area of attention, inter alia, for concerns of efficiency, the positive impact their privatisation has on capital market development and FDI as also in support of the newer belief that state should roll-back from its ownership role. The DFIs also are under a process of restructuring that may call for induction of new owners and changes in Board compositions or even conversion into universal banks.

1.10 Considering the overall dominance of commercial banks and the developing nature of capital markets, central banks probably have even a greater role to play in governance. The function of ‘contestability’ may have to arise from the Central Banks and the Stock Exchange Regulators than from the market as such.

1.11 In the case of the banks, the regulator is concerned with the following four aspects of the system, which should also be shared by the Boards of Directors by virtue of their fiduciary duties of care and diligence:

a. The fact that the depositors have a coordination problem that prevents them from sharing information and exerting sufficient pressure on the bank,
b. That the banks assets are relatively illiquid that poses a threat to the depositors whenever there is a distress for the bank
c. That the transactions of the bank while lending the depositors money are opaque or less transparent primarily because of the case by case approach inherent in appraisals of proposals and lastly
d. That the potential for contagion effect which might portend a run on the deposits in the same class of banks thus attracting a systemic risk.

1.12 Apart from the traditional reasoning for the regulator’s active involvement in ensuring bank soundness, there is a new reason that makes the regulators even more important than ever before, which should also be the concern for the Boards. In the increasingly integrated markets there is a potential of not merely regional crises but one that may affect the entire world. It is for this reason that countries and multilateral organizations have begun to look at the entire architecture of finance and a convergence and coordination at a global scale that would mitigate systemic risk for all.

1.13 Because of the delicate balance needed between enhancing efficiency and ensuring stability of the banking system, particularly in the case of developing countries, the quality and the type of regulation becomes paramount to ensure that there is sufficient flow of resources on an increasing scale into the system while monitoring that there is no undesirable hemorrhage that would warrant critical care in the form of bail-outs and lending of last resort or the fall back on deposit insurances. Such process of regulation can be intensive or intrusive if the potential risk remains unmitigated through internal governance processes. However, if the regulation is intrusive, inappropriate, or oppressive the effect on the growth of the financial system will be as deleterious as that of a “medical nemesis” (Ivan Illich). The scope for making regulation more appropriate arises both from the need for objective and logical public policy making that ensures that there are no ulterior motives in continuation of a regulatory regime or of new initiatives apart from issues of competence of the examiners themselves. At the same time, self-regulation by good corporate governance acts as a disincentive for inappropriate or intrusive regulation invoking the larger interests of stakeholders.

1.14 Financial institutions have an extraordinary stakeholder system compared to the real sector. The nature of the business and its accountability to the omni present regulator as well as the tenuous nature of reputations and their impact on stability makes governance a tougher proposition altogether. Boards thus have a greater responsibility towards their stakeholders, especially the financial stakeholders. Often, the raw material suppliers (depositors) are also the consumers (borrowers) and the service cannot be easily stored and the damage cannot be satisfactorily covered by a warranty. The service has to be literally real time, based on mutuality of interest and trust and is highly information centric. The onus on the Board becomes as much daunting as is the sector for having to deal with high risk and intangible assets and liabilities covering a large mass of public and which can assume great fragility on the basis of information or disinformation. The Boards also lend themselves to ‘contestability’ not so much by the markets as much by the regulators themselves.

Boards in Financial Sector And Competencies:

2.0 The special place of the financial system, its relevance for economic development, its structural issues, the regulatory dynamics and the stakeholder sensitivities imply special care and attention to the Boards. The structure, competencies and processes of the boards in the banks and financial institutions assume as much criticality as the DNA for the circulatory system for the human body.

2.1 Many boards of the banks and DFIs instituted by the government have had legacy systems that do not necessarily conform with the current principles of corporate governance. For instance, it is generally the practice to have an Executive Chairman than a separate position of Non-Executive Chairman. It is also a practice to have a large number of nominated directors of whom some may be representing the government or even the regulator. In some cases, the regulator also has been known to be a significant equity holder of a bank or a financial institution resulting in conflicts of interest and role confusions. Unlike the manufacturing sector, it is possible that the non-executive directors are more in number in these institutions and yet their independence and their quality is not beyond doubt. The average size of the Boards in state controlled as well as private financial institutions appears to be smaller than the international average.

2.2 A poor Board in terms of competence implies potential connected lending, increased non-performance assets, nepotism, spiriting away of funds, and attraction of risks for the depositors` funds and of course, diminution of shareholder value. It is abundantly clear that the soundness of financial institutions is first and foremost the responsibility of its owners and managers to be fulfilled by instituting an appropriate internal corporate governance structure, systems, and processes where by the Board of Directors act competently and responsibly. Yet the incentive mechanisms and the competence levels do not enable such action.

2.3 Boards that are dominated by a majority share-holder who hijacks the management for connected lending, personal benefit, graft and frauds not only bring distress to the share-holders and the immediate stakeholders (depositors and employees) but also attract systemic risks that cause wide suffering. Policy makers, regulators and owners must be able to discern the linkages among their short-term actions and the wider repercussions. Such appreciation requires deliberate advocacy and competence building among all concerned of the interconnectedness that does not assure anyone of “no come-backs”. The obvious to the knowledgeable has not been so obvious unless trained to the many who are the potential directors, examiners and policy makers.

2.4 Apart from the generic knowledge and competencies on the macro reasoning and micro conduct as implicit in the above argument, Directors in the financial system need special inputs to be able to monitor and manage risks. The risk portfolio of a financial institution is obviously not similar to that in the real sector of the economy. These risks are primarily intangible that deal with promises, expectations and their fulfillment. The Federal Reserve Board of the US had listed the following as a typical profile of risks for Banks.

a. Counterparty credit risks: The risk that the counterparty will fail to fulfill the credit contract. The size of the loss is the replacement cost of the contract in the market;

b. Market risks: Risks arising from market price changes, such as interest rate risk, exchange rate risk, and commodity price risks;

c. Settlement Risk: The risk that one party (or agent bank) will not settle or deliver final value when settling a contractual obligation.

d. Operating risk: Losses due to inadequate internal controls, procedures, and operating equipment, software, and systems;

e. Liquidity risk: Losses that result if forced to sell under illiquid market conditions;

f. Legal risk: Losses caused by uncertainties in the legal definition of obligations or court reversals of commonly understood obligations.

g. Aggregate risk: Sometimes called systemic or inter-connection risk. Failure of one party triggers failure elsewhere in system (for example, contagion)”.

2.5 Financial institutions are important players in foreign exchange, derivatives, and also equity markets within the set guidelines. Risk control systems are essential so that the typical cases of the Barings do not recur. One recalls the complacency and ineptitude of Boards that have made long-standing giants falter and collapse. It is possible that some of the directors in the BCCI were complacent and ignorant than complicit, to have become party to the international scale illegal activities perpetuated by the bank. In this context, bank Boards need extraordinary skills to not merely ask the formula questions on these risks but have the depth of knowledge to be able to constantly undertake “non-destructive testing” and ensure conformity and compliance with national and global standards.

2.6 The increasing levels of globalization implies higher levels of competition by those whose brands are strong, who have internationally derived knowledge base and who have deep pockets and abilities to take more risks on all fronts. Consolidation among financial institutions that is evident in some parts of the world also portends risks and opportunities that demand strategic thinking. Boards in S.Asia have been relatively less trained on strategy and more on reflexive rituals. New positions and competitive spirit must accompany probity lest “they are rearranging furniture as the titanic is sinking” (YRK Reddy). Boards also need the knowledge to be able to finely brainstorm competition, emerging scenarios, strategic choices, trades-off and repositioning. For instance, the importance of retail banking, Internet banking and “life-style” banking were ushered in by new banks, which have probably usurped the market potential of the long-standing giants. A slew of new products and services that contribute to better profitability, working on “economies of scope” with relatively lower risks, are possible for those, which are strategically focused. The Boards that are less knowledgeable may contribute to complacency that leads to loss of market share as well as the risks of late entry and adverse selections of clients.

2.7 Executive/Working Directors would have some advantage of knowing the manner in which for instance, a bank’s balance sheet is different from the others and also the requirements of the CRR, SLR, and other regulations. Even they may not be familiar with aspects of strategy or with the new risks and opportunities in the foreign exchange market and the derivative markets. They may also need current knowledge on the guidelines issued by the BIS/BCBS and world-class standards. For instance, IT security in the banks have been identified as a major risk in the recent past and the directors’ fiduciary duties would imply that they check the risk management procedures. Like wise, financial institutions have become major players in evaluating and advising in mergers, acquisitions, and their valuations and actually take on the derived risks which again should be in the knowledge domain of the directors to be able to recognize risk and “tap on the sensitive spot”.

2.8 The profile of risks for a financial institution are typically those related to interest rates; credit; off-balance sheet; technology and operational; foreign exchange rate; country/sovereign risk and liquidity risk. Directors ought to know the broad nature of these and the way these can be hedged through various types of forwards, futures, swaps, and options. Directors also need to understand the manner in which global companies are addressing these risks and establishing internal control mechanisms beyond that required by law.

Consequently, if the Boards of financial institutions have to fulfill their fiduciary responsibilities and also fulfill their duties of care and diligence, there is no option but to gain the technical competencies required for this business. These competencies must be built on a strong foundation of generic competencies. The CACG has by now established itself as a pioneering leader in training directors in generic and strategic competencies which should form the essential foundation to build on.

An Approach:

3.1 Training of directors of financial institutions may be new in some countries. The experience of the CACG is noteworthy in sensitizing, advocating and training a mass of directors including those from the finance sector imparting the essential knowledge. The American Association of Bank Directors probably offers some idea of the competence needs and short modules that are very specific to the Banks. There is also some basic literature for bank directors that have been published. Bank examiners in Kansas had also brainstormed and came up with a list of dos and don’ts for bank directors (the last of which includes an advice not to argue with an examiner. It is like wresting in the mud with an “elephant”. Eventually, you figure out that the “elephant” enjoys it).

3.2 An approach is to train directors and potential directors sectorally by giving them special training in generic and strategic competencies on a mass-scale for all Directors and potential directors followed by sectoral competencies (competencies specific to the community/cooperative banks; insurance companies; large commercial banks; DFIs; Mutual Funds, Venture Capital Firms; deposit taking non-banking financial institutions; other service providers, the regulators/examiners etc.)

3.2 The approach (which is being experimented by the Academy of Corporate Governance in the case of commercial banks, NBFIs and Urban Cooperative Banks in India) may consist of :

a. A national level conference of the segment targeted to sensitize the critical aspects of corporate governance and its relation to the well being of the sector in the long term or for immediate rejuvenation. This conference will bring about a consensus as well as ownership of the action to be followed. An industry level CEO team may be established to chalk out the agenda which will include preparation of the case studies of successes and failures in corporate governance; competence mapping of the ideal board directors; preparation of model practices and the like.

b. The next phase will comprise of designing a program in such a way that the common competencies are standardized for important segments of the Finance system (generic competences relating to the Corporate Governance theory and principles, directors roles and responsibilities, ethics and CSR, board dynamics and the like and those relating to strategy). Needless to state, the CACG template is eminently suited to the developing world.

c. These modules may be followed by validated specialist modules that address the chosen segment. (for instance the issues of Cooperative Banks will be entirely different from those of a company; the knowledge and competencies for insurance will obviously be different from those of the mutual funds; the Board of a DFI will need to know lesser on retail marketing or payment system than credit and liquidity risks; the due diligence in a Venture firm is more entrepreneur centric than finance-centric one of M&A Advisory).

d. The last would be of standardization and deployment throughout the sector through self-funding or multilateral funding or a combination thereof. (the manner of deployment adopted by the IFC in he case of Russia, Ukraine, Armenia and Korea may give some further knowledge - IFC Annual Report-2002)

CONCLUSIONS:

4.0 In conclusion, the financial system in South Asian region has great potential for growth that will contribute to economic development as well as poverty reduction. In the process of its development and sophistication, it may still have to rely on the dominant structures of banks and the large FIs for some years to come as other types of smaller institutions and capital markets do not yet contribute to a significant portion of the economy. They will, in due course, create sufficient number of channels for delivery of credit and services into the system and spread risks better. While stock exchanges have existed for decades, their development and autonomous regulation or capital markets have been more recent. Consequently, the Financial System is in a transition from the planning era of “command, control and coordinate” to a futuristic free-enterprise driven by active capital markets. Till capital markets are well developed, it is expected that the regulators will perform some function of “contestability”.

4.1 In the financial sector, banks occupy a special place not only because of their specialized nature and importance but also because of the need for regulators to ensure that the public policy interests are actively monitored and satisfied. These interests arise due to the wide spread nature of depositors, their information coordination problems, the potential for spiriting away funds, the risks of the contagion as also systemic risks that may engulf a wide region. The regulatory and control structures should be appropriate to enable the development of financial system rapidly while managing risks. The issues before the policy makers obviously involve resolution of government ownership, regulatory overlaps, role demarcations and related aspects that can facilitate even a better climate for corporate governance.

4.2 The critical challenge for the financial institutions is to develop their Boards by appropriate restructuring and competence building not only for keeping the regulator and the stock exchange regulators away but also for reasons of accretion to shareholder value. The structural issues of executive chairman, board committees, nominee directors, etc. are obviously important and need to be addressed both by the regulators as well as the owners. Boards need the generic competencies to appreciate the importance of corporate governance and its interconnectedness to well being at all levels.

4.3 A notable requirement in the face of integrating and liberalized markets is development of strategic abilities among the board members so that they are in a position to steer the organizations through the increasingly complex choices of products and markets that can reposition the organization to handle competition better. The CACG course offers a useful basis for developing both the generic and strategic competencies for the finance sector.

4.4 It is obvious that financial institutions are exposed to a different profile of risks than the real sector. Risk profile is getting complex and technical by the day. Directors need exposure to understanding the range, implications, and potential impact of these risks as also the availability of techniques, products and internal structures by which risk management can be improved. Thus, directors need a host of additional competencies apart from the generic and the strategic ones. These competencies are primarily in understanding and managing risks such as interest rates, credit, off-balance sheet, technology and operational, foreign exchange, country and liquidity risks. The availability and dimensions of products to manage these risks are also important knowledge for the directors. In addition, directors are required to follow the important guidelines and norms being set by multilateral bodies such as the BIS and world-class organizations. While this may appear new ground, there are templates that can be borrowed and customized for the South Asian region.