There are scores of Urban Cooperative Banks in India (akin to Credit Unions) that are considered weak In recent years some had failed and had to be bailed out by the Government under accusations of promoting moral hazard. The weakness and failures among UCBs appears to have arisen not due to any lack of technical knowledge. A dipstick analysis indicates their strong linkages with the true purpose/mission in establishing the UCBs, which in turn creates the structures, systems, and processes of cooperative governance. Where the intention of the promoters has been to utilize the opportunity to run a business, the principles of cooperation are flouted with impunity, which in turn impairs independence, transparency, disclosure, and accountability. On the other hand, where the mission/purpose was primarily built upon cooperative principles and philosophy, democracy appears to prevail. This, in turn, supports members’ involvement and checks to ensure self-dealing, connected lending, and corrupt practices are avoided. It may be worthwhile for the licensing authority to carry out due diligence of the true purpose of those who have come together to form a cooperative, than permit adventurism and then trying to regulate or reform them.

Editor

(Any views and opinions expressed by authors, writers in this e-journal are of their own.
Corporate Governance Journal is not responsible for the facts, figures, views,
and statistics that appear in this journal.)

Corporate Governance and Financial Institutions

by
Shri Vepa Kamesam

(Speech delivered by Shri Vepa Kamesam, Chairman, Governing Council, Institute for Development and Research in Banking Technology (IDRBT), Hyderabad at the top management workshop on Corporate Governance & Corporate Social Responsibility in Public Enterprises, organized by ICFAI and Indian Institute of Public Administration at New Delhi on 8th July, 2004. Speaker greatly acknowledges to various references, OECD publications, BIS Reviews and other documents and press releases of RBI, SEBI etc. The opinions / views expressed in this speech are that of the author.)

The subject given to me is to speak about financial institutions, which if one would look from right perspective would encompass all the financial institutions within our country. Particularly, you may divide them into following:

• Term-Lending Institutions, governed by the Companies Act or Special Act
• Banks [public sector, private sector (old and new generation banks, Cooperative Banks)] governed by Special Act or BR Act.
• Finance companies also known as non-banking financial companies governed by Companies Act and guidelines issued by RBI and FCS.

The Basel Committee in the year 1999, had brought out certain important principles on corporate governance for banking organizations which, more or less have been adopted in India.

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 managements accountable. The underlying theme is accountability at all levels including the Boards.

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 recognized 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 ofcourse protect the interests of depositors, which is supreme.

You may be aware that the Committee has issued several papers on specific topics, where the importance of corporate governance is emphasized. These include Principles for the management of interest rate risk (September 1997), Framework for internal control systems in banking organizations (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 aspects 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 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. The latest directive issued by RBI on 25th June, under section 35A of the BR Act is very important. Certain criteria must be fulfilled by persons aspiring to become Directors of Banks and due diligence must be done in this regard. In future, Directors must also execute covenants binding themselves to discharge the duties, rules individually and collectively. Qualification, track record, integrity and other ‘fit and proper’ norms, importantly duly filled in forms must be scrutinized by Nomination Committees.

The supervisory experience of Regulators in general, in banks consider the following as critical elements in the governance process:

• Establishing strategic objectives and a set of corporate values that are communicated throughout the banking organization.
• Setting and enforcing clear lines of responsibility and accountability throughout the organization.
• 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.
• Ensuring that there is appropriate oversight by senior management
• Effectively utilizing the work conducted by internal and external auditors, in recognition of the important control functions they provide
• Ensuring that compensation approaches are consistent with the bank’s ethical values, objectives, strategy and control environment.
• Conducting corporate governance in a transparent manner
• Ensuring an environment supportive of sound corporate governance.

I would like to discuss these practices in some detail, as dealt with by Basel Committee.

Regarding establishing strategic objectives and a set of corporate values that are communicated throughout the banking organization, Basel Committee feels that it is difficult to conduct the activities of an organization when there are no strategic objectives or guiding corporate values. Therefore, the board should establish the strategies that will direct the ongoing activities of the bank. It should also take the lead in establishing the “tone at the top” and approving corporate values for itself, senior management and other employees. The values should recognize the critical importance of having timely and frank discussions on problems. In particular, it is important that the values prohibit corruption and bribery in corporate activities, both in internal dealings and external transactions.

The board of directors should ensure that senior management implements policies that prohibit (or strictly limit) activities and relationships that diminish the quality of corporate governance, such as:

• conflicts of interest;
• lending to officers and employees and other forms of self-dealing (e.g., internal lending should be limited to lending consistent with market terms and to certain types of loans, and reports of insider lending should be provided to the board, and be subject to review by internal and external auditors); and
• providing preferential treatment to related parties and other favoured entities (e.g., lending on highly favourable terms, covering trading losses, waiving commissions).
• Prohibiting insider trading based on knowledge of sensitive information before it becomes public knowledge.

Processes should be established that allow the board to monitor compliance with these policies and ensure that deviations are reported to an appropriate level of management.

On the practice of setting and enforcing clear lines of responsibility and accountability throughout the organization, Basel Committee says that effective boards of directors clearly define the authorities and key responsibilities for themselves, as well as senior management. Such boards also recognize that unspecified lines of accountability or confusing, multiple lines of responsibility might exacerbate a problem through slow or diluted responses. Senior management is responsible for creating an accountability hierarchy for the staff, but must be cognizant of the fact that they are ultimately responsible to the board for the performance of the bank.

Regarding the practice of 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, Basel Committee stipulates that the board of directors is ultimately responsible for the operations and financial soundness of the bank. The board of directors must receive on timely basis sufficient information to judge the performance of management. An effective number of board members should be capable of exercising judgement, independent of the views of management, large shareholders or the government. Inclusion on the board, qualified directors that are not members of the bank’s management, or having a supervisory board of board of auditors, separate from the management board, can enhance independence and objectivity. Moreover, such members can bring new perspectives from other businesses that may improve the strategic direction given to management, such as insight into local conditions. Qualified external directors can also become significant sources of management expertise in times of corporate stress. The board of directors should periodically assess its own performance, determine where weaknesses exist and, where possible, take appropriate corrective actions.

According to the Committee the Boards of directors add strength to the corporate governance of a bank when they:

• Understand their oversight role and their “duty of loyalty” to the bank and its shareholders;
• Serve as a “checks and balances” function vis-à-vis the day-to-day management of the bank;
• Feel empowered to question the management and are comfortable insisting upon straightforward explanations from management;
• Recommend sound practices gleaned from other situations
• Provide dispassionate advice;
• Are not overextended;
• Avoid conflicts of interest in their activities with, and commitments to, other organizations; meet regularly with senior management and internal audit to establish and approve policies, establish communication lines and monitor progress toward corporate objectives;
• Absent themselves from decisions when they are incapable of providing objective advice;
• Do not participate in day-to-day management of the bank

It is found that in a number of countries, bank boards have found it beneficial to establish certain specialized committees. Let us look at a few of them:

• Risk management committee: It provides oversight of the senior management’s activities in managing credit, market, liquidity, operational, legal and other risks of the bank. (This role should include receiving from senior management periodic information on risk exposures and risk management activities)
  
• Audit Committee: It provides oversight of the bank’s internal and external auditors, approving their appointment and dismissal, reviewing and approving audit scope and frequency, receiving the reports and ensuring that management is taking appropriate corrective actions in a timely manner to address control weaknesses, non-compliance with policies, laws and regulations, and other problems identified by auditors. The independence of this committee can be enhanced when it is comprised of external board members that have banking or financial expertise.
  
• Compensation committee: It provides oversight of remuneration of senior management and other key personnel and ensuring that compensation is consistent with the bank’s culture, objectives, strategy and control environment
  
• Nominations committee: It provides important assessment of board effectiveness and directing the process of renewing and replacing board members.

Even in very small banks, key-management decisions should always be made by more than one person, which is known as “four eyes principles”. It is also necessary to put strict ‘firewalls’ between the persons involved in the frontline business taking risks and decisions, getting involved in framing policies or serving in any of the important set of committees like the Audit committee. The philosophy of the Board must percolate to every employee in the organization that the Board is not unwilling to discipline successful or key employee when he goes wrong and the company do not fear losing such persons. The scenario in the Indian banking situation is - several audits takes place continuously beginning with the statutory auditors, the internal auditors, the concurrent auditors (who could be internal or external) and occasionally audit from the CAG and ofcourse the regulatory oversight / inspection by the Reserve Bank of India under Section 35 of the BR Act. There is also a risk rating of each bank on the CAMEL parameters and managements of the banks are called in for discussions with Regulators to express their concerns in certain areas. In respect of public banks, the majority is held by the government as such regulatory concerns are also periodically and confidentially shared with the government as well. Ownership and shareholding in PSU Banks is actively under debate with the government desirous of having a golden share with special rights should it disinvest more than 51% of the shares sometime in future. Recommendations of Narsimham Committee I & II are relevant.

For the same reason of governance, I would like to raise an issue - Should there be officials of RBI on the Boards of the Banks and would there not be a conflict of interest in the role of a Regulator and a Board member taking the decisions? Likewise Government servants serving on the Bank Boards also raises a similar issue. I am aware there is no immediate resolution to this dilemma but a compromise could be worked out by having well reputed eminent professionals as nominees in the transition period before totally exiting from the Boards.

It is true that only a “fit and proper” person can be appointed as a Director of a bank and very recently Reserve Bank has issued guidelines on this subject to which I made a brief reference already. It is very necessary that the Directors seriously address themselves to the various risks that the bank faces particularly in their operations in the various types of businesses and to design proper risk mitigation measures and to adopt suitable measures for effective control so that the risk is mitigated. Banking, per-se, involves risk taking and one need not and should not be afraid of taking a decision as long as the Board or the executive suitably empowered, ensures that you have recognized the risk and taken the decision in transparent manner and the Board is quite competent to handle it.

It is also well known that when certain financial parameters are breached, like the well known trigger points, action is taken immediately to put the bank on proper monitoring till such time it improves. Despite all these changes and a better appreciation of each other’s affairs, it is true there have been serious problems in some Banks and also in Cooperative banks both DCCBs & Urban Banks. The time to make a judgmental call in placing a bank under moratorium and subsequently merging it with another stronger bank or liquidating is not an easy decision. Friends, it brings me to the most painful subject of governance in the cooperative banking sector. I had spoken on an earlier occasion in July 2002, on this very same subject where because of these institutions reporting both to the Registrar of Cooperative societies and to the Reserve Bank of India there have been cases of regulatory arbitrage. It is also widely known that in Cooperative banks the general principle of governance of collective decision making is not always followed resulting in related parties being shown special favours, accumulation of non performing assets (NPA), loss of profit by bidding for deposits at excessive rates and weak and inadequate action where required by the respective state governments have all contributed to the sad scene. Some other district cooperative banks have lost moneys in the so called investments of purchasing government securities to meet the SLR requirements. It is a nightmare to entrust Rs.100 crores to a broker, who neither delivers the scrips purchased nor renders an account for the purchases. I would not like to go into a host of other delicate and sensitive issues but, I would only reiterate that Regulators may be looked upon as external pressure points for good corporate governance. Disclosure and transparency are also very important so that all the stockholders can judge the strength and weaknesses of a bank. Collective decision making by “fit and proper” professional directors and last but not least, as all credit institutions are linked to each other through a complex chain of inter-bank relationships which – as recent instances have showed – in any event of difficulty, become mechanisms for spread of the ‘contagion’ effect has to be arrested at the earliest. Vulnerable in this chain is default in payment systems and clearing facilities. RTGS reduces this risk largely. Cooperative banks were built on human capital and did exceedingly well for about 50 to 60 years. Its time to introspect and see how the lost luster can be regained using the tool of corporate governance, risk management etc., and also bringing about legislative changes so that a single Regulator regulates a financial entity or corporate entity to prevent arbitraging. I strongly believe, State Governments must not hesitate to take strict action where warranted against the DCCBs rather than mild or no action being taken and also reconcile to a single Regulator even if it meant losing a part of the turf and power.

Let me now go back to the Dr. Ganguly Group’s Report submitted in April 2002 and placed at RBI’s website for comments. Banks were advised to place the report to their Boards to adopt the decisions constrained therein, some of which required legislative changes have been referred to the Government of India.

Thus, it is the collective wisdom of eminent professionals serving on the Boards of the financial institutions, which can further enhance corporate governance. I am afraid this search for improvement is not limited by time. It would continue forever and it is only hoped that scamsters are brought to justice sooner than later. There is an entire subject called ‘whistle blowing’ and there is enormous literature on this subject. When to blow the whistle? Who should blow the whistle? And where should the whistle be heard? These are the questions for which one need to find the answers between spate of anonymous letters to which any one working in public sectors is used to and often honest officials harassed on one side, to which thanks to CVC are now ignored, and damaging investigative audit reports and doctored Balance sheets on the other side. Somewhere in between lies the governance and ethics and standards set up by virtuous men heading institutions. In such institutions the reputation of the organization and the leader go hand in hand. In such organizations the shareholders and other stakeholders truly derive their value. It is myopic to look for astronomical return by the shareholders to allow the Boards to indulge in unethical practices like market rigging, insider trading, speculation and host of other irregular practices for making huge profits. One cannot argue that the shareholders value is enhanced and higher profits and dividends are distributed, the Board acting as agent of the shareholder being the principal. Here lies the real test of governance of the Boards walking the well defined, honest and straight path in conducting the affairs in the required atmosphere of transparency, seen and perceived by all the stakeholders and the markets and regulators. Then only can one confidently state that corporate governance has taken firm roots in the countries.

Friends, I thank you for your patience in listening through this somewhat lengthy, important and sensitive subject as understood by me, after being on the Boards of State Bank of Travancore, State Bank of India, SEBAL, SBI Mauritius and SBI Canada, NABARD, NHB and Reserve Bank of India finally before I retired. I thank the organizers for inviting me to speak today.

• Cash on hand
• Balances with other banks
• Investment
• Loans and advances
• Fixed assets and
• Other assets

• Whether the UCB has documented its loan policy?
• Whether procedures prescribed and practices followed for appraisal, sanction, and documentation are adequate and consistent with the normal banking practices?
• Whether there are appropriate delegation of powers where required?
• Whether post sanction monitoring and follow up of advances are adequate and effective?
• Whether internal control and audit functions prescribed and carried out are adequate and strictly adhered to?
• Whether the overall quality of the loan portfolio remains in fine fettle? If there is impairment, whether remedial action has been initiated to improve the quality? Whether adequate provisions to cover the erosion in the value of loan assets has been made?

• Compromise on principles of sound lending
• Lack of competence and standard appraisal procedure
• Want of credit information
• Lack of effective supervision
• Complacency
• Poor selection of credit risks
• Overlending.

• As a regulator I expect the UCBs to provide sterling customer service, and put in place a process of addressing customer grievances with the required promptness.
• The process of detective and punitive vigilance within the bank should be dynamic.
• The asset-liability management should have a strong presence.
• Appropriate systems and control including a well laid down audit process which are critical for efficient functioning of a bank should be in place.
• There should be greater transparency in the balance sheets by subscribing to disclosure standards conforming with international standards.
• UCBs should acquiring a technological edge.