Do companies have wider social responsibility, beyond compliance of law and regulations, is a question that has been debated for long. In a recently held seminar at New Delhi, this was debated again. Most participants felt that social responsibility starts with good governance in the interest of the shareholders. Involvement of the company in socially relevant and community-related issues enables the company to improve its acceptability and image. A number of examples were brought out at the seminar, on how leading companies have engaged in wider social issues. It was also pointed out that business schools can help imbibe in the future managers, a sense of social responsibility.

Shareholders activists are gearing up for a busy season in the US as the annual general meetings of the shareholders get underway in March. According to Professor Jay W Lorsch at the Harvard Business School who specialises in corporate governance, “Many investors remain irked. This is all about shareholder empowerment in the governance process. My sense is that everybody is agitated by the misdeeds of the past few years – the accounting problems and the executive compensation issues.” We invite rejoinders from readers on both the issues of ‘social responsibility of corporates’ and ‘shareholder empowerment’.

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 in Financial Intermediaries

by
Dr. MK Datar
Economic Research Department, IDBI

(Published in Economic and Political Weekly in January, 2004
and reproduced with permission)

I. Introduction:

Though corporate governance (CG) has become an extensively researched and debated topic, unique corporate governance issues that arise in the context of banks and financial institutions, i e, financial intermediaries have been generally discarded. This is a bit surprising as an extensive survey on corporate governance [Sheleifer and Vishny 1997] considers that corporate governance “deals with the ways in which suppliers of finance to corporations assures themselves of getting return on investment”. Thus, the potential role of financial institutions in maintaining good corporate governance standards among their borrower clients is considered significant, and they are suited to monitor corporate and managerial performance due to their high (debt or equity) stake in a large number of companies. Also in times of financial crisis or irregularities, the macro issue of stability and efficient working of the financial system does come to the fore, but the micro issue of governance standards in banks (and more generally financial institutions) themselves is rarely discussed. This could partly be due to the fact that financial institutions, and banks in particular, are heavily regulated. This leads to questions about whether regulation is a substitute for or complimentary to governance standards. But as good governance is likely to facilitate regulation and supervision, a case may be made for the explicit analysis of corporate governance in financial institutions. Moreover, regulators themselves are emphasising the need to maintain good corporate governance standards in the entities they are regulating or supervising [Jalan 2002]. While the market for corporate control and regulatory restrictions are external mechanisms of corporate governance, standards prescribed for responsibilities of different constituents of a corporation, remuneration and performance monitoring of executives and the audit function are internal mechanisms. These two mechanisms are likely to be complementary.

It has been argued that corporate governance mechanisms would be country specific as they would depend on the development of financial systems and funding requirements of the industrial sector. Another related and interesting issue could be whether corporate governance is industry specific. While there are several corporate governance issues that are common between financial institutions and banks, viz, relationship between shareholders and the board of directors, division of responsibilities between board and management, role of audit committees, there are several reasons which would justify separate treatment of CG issues in financial institutions. Liu (2002) lists the predominance of depositors who have a fixed claim (vis-à-vis shareholders) moral hazards inherent in banking leading to agency costs and the fear of bank runs, as the reasons for the importance of CG in banks. [Macey and O’Hara (2003)] highlight the unintended effects of deposit insurance on the risk tolerance of bank managers. It has also been argued that in the ‘new’ businesses (such as banks or software companies) where human capital and not physical assets are important, not ownership but access to critical resources becomes important. Hence new governance mechanisms would be required in such enterprises [Rajan and Zingales 2000].

This paper argues that certain governance issues are peculiar to financial institutions and therefore different mechanisms would be necessary to maintain good governance standards. While regulators and supervisory authorities seek to maintain stability of the financial system, other mechanisms that focus on the working of individual institutions, play a complementary role and reduce the regulatory burden on regulatory/supervisory authorities could be useful. Governance in financial institutions is an important micro aspect of the working of financial institutions. The question of corporate governance would also be important in the context of the relative efficacy of bank based and market financial systems [Takagi 2000]. Corporate governance norms become important because the market for corporate control is not always effective. Similarly, competition in product markets may keep management on its toes but it cannot become a substitute for good corporate governance. Moreover, as banks and other financial institutions are important operators in capital markets, governance in financial institutions is a relevant factor in the context of effectiveness of capital markets.

The rest of the paper is arranged in two sections. Section II analyses peculiar factors that renders CG in financial institutions different from other entities. Section III suggests certain mechanisms to ensure good governance standards in financial institutions in light of the peculiarities analysed in Section II. The paper ends with concluding observations.

II. Alternative Governance Mechanisms: Institutions and Markets

Transaction cost theory holds that firms have an advantage over markets in minimising transaction costs. From the perspective of agency theory, a firm is a bundle of contracts. However, the contracts relevant for markets and institutions (hierarchies) are different. While markets operate on classical contract law, which are applicable to ideal transactions, firms are based on law of forbearance [Williamson 1996]. Classical contract laws assume thick markets and the identity of transactors is not relevant. Firms thus have an advantage in dealing with situations in which contracts are incomplete. Financial institutions can internalise certain risks which markets do not or will not. Contract law does not govern decisions within a hierarchical organisation. Even courts would refuse to rule over interdepartmental disputes within an organisation. These decisions are administrative and the incentive intensity is comparatively low. A government department is perhaps pure hierarchy where decisions are fully administrative. But commercial entities operating in a competitive market environment need to adopt a hybrid form, which combines some features of markets and hierarchies.

Power in Financial Institutions

Traditionally, power in an organisation is associated with the ownership of physical assets. These assets are unique to companies and by utilising such assets cash flows are generated. As equity shareholders jointly own these assets, agency cost becomes an important governance issue. However it has been argued that in new types of firms, the power is associated with access to use of critical resources and not their ownership [Rajan and Zingales 1998; Rajan and Zingales 2000]. Physical assets are not important in the working of advertising agencies, consultancy firms or financial institutions. In financial institutions power would be associated with extending loans. While deposit taking is an important activity of banks and quality of service, its delivery mechanism, etc, would certainly be important in attracting deposits – ultimately the ability of banks to meet their commitments depends on their portfolio management capabilities. While banks deploy their deposits funds by way of lending and investing, the essential difference is in exit mechanisms associated with them. In the presence of deposit insurance with uniform premiums, what distinguishes one bank from others is their portfolio management skills.

Governance Issues in Lending

Lending is essentially giving money today against a promise to pay money tomorrow. As a result, identifying good dependable clients and monitoring their performance till the loan is repaid is a necessary banking function. This activity is information intensive and knowledge about potential clients is required. Lending activity inevitably involves risk and the choice is about the degree of acceptable risk. Loans may turn bad as a result of wrong business decisions, which are unavoidable to some extent. But loans may turn bad also if loan appraisal is faulty or client performance is inadequately monitored. Loans also turn bad if bank managers, in connivance with project promoters, become a party to ‘looting’. It is difficult, post facto, to distinguish between all these probable causes of loans turning bad. It is, nevertheless, essential that the management deal with the different situations leading to loan default appropriately. While the first situation is unavoidable, the second would necessitate proper appraisal and monitoring systems, which is embedded with risk measurement, and mitigation measures. One definition of a governance structure as, “an institutional framework in which the integrity of a transaction or related set of transactions is decided” indicates its crucial importance in the activity of lending. It would be difficult to carry out lending activity in a sustainable manner unless the lending agency has internally accepted norms regarding: (i) Methods of appraisal and monitoring, (ii) An acceptable risk profile? and (iii) Mechanisms by which adherence of (i) by all is monitored and a set of incentives and disincentives is put in place so it can be implemented.

In an imaginary situation where a firm undertakes lending financed only by its internally generated funds (all equity is raised by promoters) the governance mechanism would consist of essentially personnel or HR functions. These would be selecting sincere people, training them and developing a performance monitoring system and a reward/punishment system so that employee motivation is maintained. The important and complex task would be to develop a unified, institutionwide view on what is acceptable risk. The risks would be higher in the financing of green field projects where setting up of projects takes a long time. And it would be necessary to distinguish between bad business decisions and deficient performance on the part of managers.

The success in lending, essentially choosing and maintaining of assets, is measured by the returns generated but these would essentially depend on the internal governance mechanism. Every financial intermediary, be it a bank, mutual fund or insurance company, is involved in choosing and maintaining financial assets. Where capital markets are well developed, funds would be invested, rather than lent, in securities of different maturities. With liquid secondary markets, decisions can be corrected or ‘undone’ by selling these securities. This option is not available in the cases of loans, which are generally held till maturity.1 Mutual Funds manage unit holders’ funds for a commission and provide good liquidity while life insurance companies undertake the same task with a longer-term perspective and hence offer low or limited liquidity. But their asset side activities are quite similar to lending and would therefore require similar governance mechanisms. The essential difference between lending and investment is in exit opportunities. With the broadening of the debt market, the dividing line between lending and investment would get blurred.

The usual CG issues such as separation between ownership and management, or conflict of interest between majority and minority shareholders or the relationship between the board of directors and the executive management are not yet relevant in the hypothetical situation under consideration. Once we allow for deposit acceptance, public shareholding and borrowing the above mentioned factors become relevant and are also important in all corporations. But the importance of HR functions, the choice of risk tolerance levels would still remain vital for financial institutions.

Liquidity and Governance

Banks have a special role in providing liquidity to investors. They offer short term or demand deposits to meet the liquidity needs of depositors and deploy these funds in relatively illiquid (but high earning) loans. These short maturing liabilities are seen as a monitoring device available with depositors because if not satisfied with bank performance, they could refuse to renew their deposits [Diamond and Rajan 1999]. With a view to maintain public confidence in the banking system, governments in different countries have provided deposit insurance to retail depositors. This has helped greatly in providing a stable basis for bank operations. However, the same arrangements create a moral hazard problem for banks because bank owner/managers can be tempted to take more risks. Such measures to assuage depositors should therefore be accompanied by measures, which would ensure that the process of asset choice and management are not excessively risky.

Liquidity is important not just from the perspective of investors’ preference and their risk appetite, but also in terms of external governance mechanisms. Effectiveness of the market for corporate control depends on liquidity but there is a trade off between liquidity and different governance mechanisms. Widely dispersed ownership would improve liquidity and attract a wider class of investors. But such wide ownership would reduce the incentives to monitor client performance; voting by feet may become more tempting. In such a scenario share prices become a tool for management performance and useful to devise management compensation packages [Holmstrum and Tirole 1993].

On the other hand, if there are large holders, liquidity would be low but there would be incentives for these large lenders/investors to monitor their clients, in which case, the market for corporate control would be more effective. When share ownership is dispersed, liquidity would be higher but management may tend to hold effective control.

Setting Risk Tolerance Levels

Risk management is an important parameter that affects the performance of a financial institution. Regulators’ aim is to encourage regulated entities to make correct risk assessments, take adequate risk sharing/mitigation measures and to hold adequate capital to bear the risk. But how much risk an institution should bear is a prerogative of the management or board of directors. Risk tolerance will also influence profitability levels and volatility therein, which makes it akin to a business decision. The acceptable risk profile will determine business quality in terms of products, sectors and clients. Acceptable risk levels will not be static; they would (or should) change in response to the changing business environment. Different constituents in a financial institution could have a different view on the levels of risk lenders should accept. Borrowers themselves would like it if lenders accept higher risks while depositors would prefer low risks.

Setting risk tolerance limits in a dynamic context and ensuring that business proposals accepted are in conformity with the acceptable risk profile is crucially important in maintaining good governance in financial institutions. This task involves not just senior management but nearly all employees. Selection of employees with suitable skills, providing a performance linked compensation package and a professional work environment are necessary to recruit and retain talent. While compensation of senior executives has been considered as an important aspect of corporate governance, human resource policies pursued by companies are considered a prerogative of managerial responsibilities. However, given the importance of skills in financial institutions, particularly in asset management, the crucial importance of HR policies needs recognition. These would operate as governance mechanism.

Governance in Banks and Non-Banks

There are several common CG issues in the working of modern large banks and corporations. Table 1 lists such mechanisms and highlights the differences among banks and non-banks.

Shareholders interests are crucial in market based financial systems such as UK and US whereas in countries such as Germany and Japan interests of all stakeholders particularly workers and lenders are considered relevant. Majority shareholders own a company and the group who has a controlling interest could run the company in ways detrimental to the interest of minority shareholders. This is a major CG issue.

In the case of banks with restrictions on owning bank shares (particularly on voting rights) it is easier to control a bank with a much smaller stake. Such a situation would arise even in the case of non-banks if equity share ownership were widely distributed, reducing the minimum stake required for controlling a company. However, in the case of banks, the stake of depositors is much larger given the high leverage in banks vis-à-vis non-bank companies. In the interest of depositors (who get assured interest) banks should invest in safe, though low yielding, projects while shareholders may prefer higher risk profiles. As regards external regulation, i e, the market for corporate control, there are limits on holding of bank stocks in several countries. This weakens the external mechanisms of corporate governance. Scope for performance monitoring by debtors too is limited in the case of debt issued by financial institutions. Prices of debt issued by banks could serve as a performance indicator for listed banks though the reliability of this indicator would depend on the depth and liquidity of such trading. It thus appears that internal mechanisms for corporate governance are most essential in the case of banks and financial institutions.

III

An assessment of claims of stakeholders other than shareholders is presented in Table 2. The extent of deposit/debt holders is computed by the debt equity ratio which is ratio between deposit/debts and net worth comprising of capital and reserves. In the case of insurance companies, the policyholders claims are treated as deposits/debt. This ratio is higher for financial institutions as compared to manufacturing firms. It is particularly high for banks and insurance companies. In the case of banks and non-banking finance companies (NBFCs) the ratio would have been higher still, before these were subjected to capital adequacy requirements.

The importance of human capital resources and the stakes of employees is assessed in terms of ratio of employee costs to operating costs. It is true that this is not the ideal way to assess the use of human capital as no dimension of skills is taken into account.

This is largely because of the lack of availability of data across all the categories. However, higher relative contribution of human capital in banks and financial institutions is noteworthy.

Regulation and Supervision

Among the factors affecting the governance mechanism in financial institutions the most important is regulation and supervision. This is quite elaborate for scheduled commercial banks, which are regulated and supervised by the Reserve Bank of India. The registrar of cooperative societies and the RBI jointly control co-operative banks. Measures are under consideration to bring cooperative banks like other banking entities under full control of the RBI. The proposed stipulations about not giving loans to directors and obtaining RBI’s prior approval for appointment of chief executives have become controversial. This perhaps indicates the importance of access to loan sanctioning mechanisms in the workings of financial institutions.
NBFCs are subjected to prudential regulations of the RBI and are required to submit periodic returns. In the case of insurance companies a separate IRDA has been established in view of the entry of private sector firms. Thus there would be three regulatory agencies, viz, SEBI, RBI and IRDA, which would regulate the financial system. The regulation of overlapping areas (bond borrowing by banks, trading in G-securities and interest rate policy) and the need to have coordination among regulators is an important governance issue.

Employee Compensation

Bank regulators have control over the appointment of chief executives and remuneration to full time directors. In other companies, it is the prerogative of the board to appoint directors and decide their remuneration. The interests of the employee are aligned with those of shareholders by linking compensation to financial performance of the company. In the case of stock options, the potential benefits depend on the level of secondary market prices. Compensation could also be linked to other ‘real’ parametres of performance viz profitability, productivity or collections, etc. However, management could manipulate these parameters and hence the importance of market price of equity shares, although indicators other than market price of equity would be necessary for non-listed entities.

There is virtually no link between performance and compensation of banks and financial institutions under government ownership, the proportion of which is quite significant. Moreover, as regards compensation of non-director employees the compensation level and performance linkage is wholly a matter internal to the organisation even in private entities. But the situation varies considerably with ownership. While compensation is believed to be performance oriented in private sector entities, in public sector entities there is no such linkage. Given the importance of employee motivation and incentive structure this is an important factor in the governance mechanism in financial institutions particularly in the context of lending activities.

Disclosure Standards

While accounting standards are stipulated for banks, cooperative banks and NBFCs, elaborate balance sheet disclosures are stipulated for scheduled commercial banks. Public disclosure of information is geared towards shareholders. If the entity is listed on stock exchanges, it is subject to listing requirements such as announcement of quarterly results and sending annual report to shareholders. The current stipulations by stock exchanges are uniform for banks and non-banks. The other stakeholders such as depositors have very little access to information.2 Life-insurance policyholders have no access to financial status of the insurance company. Similarly, depositors in unlisted/cooperative banks would get no information about the working of their banks in which they have deposits.

All financial institutions that accept deposits, borrowings from public should need to disclose information about their asset quality, liquidity, market and other risks, etc. It would be necessary to have a mechanism by which relevant information on risks faced by financial institutions is available to the public at large. The Basle II proposals consider disclosures as an important pillar of effective bank supervision. On a similar reckoning, disclosure of relevant information would be important for good corporate governance standards. Such information need not be posted individually to depositors but could be made accessible through newspaper advertisements or through web sites. Putting such information in the public domain would also facilitate monitoring by analysts or journalists. To have proper incentives for meeting disclosure standards, entities meeting these standards could get some benefits in terms of say, lower capital requirements, or providing links to executive compensation.

Concluding Observations

The relative neglect of the explicit discussion of CG issues in financial institutions could partly be due to regulation and supervision of these entities. However, external mechanisms are a poor substitute for internal mechanisms. Regulatory processes too are evolving and internal mechanisms could complement the efforts of regulatory authorities. The power to extend loans is most important distinguishing feature of financial institutions. Maintaining integrity of transactions in lending, an inter-temporal activity, is of utmost importance. The choice of proposals, risk assessment, project monitoring are all skill incentive activities. Thus HR policies pursued by banks could potentially be an important mechanism for maintaining good corporate governance standards. It would be desirable to introduce a performance linked compensation system in all financial institutions.

Current disclosure standards vary across financial institutions and are geared to provide information to shareholders. Moreover, at present there are no disclosure standards for providing information to shareholders in unlisted entities (co-operative banks) and other stakeholders such as depositors or insurance policy holders. However, putting relevant information on portfolio quality and liquidity and market risks in the public domain could be an alternative mechanism to improve transparency in working of financial institutions.

This paper has not worked out the specifics of linking compensation to performance, performance measurement criteria under different functional categories or information disclosure. It also does not take into account the implications of government ownership for governance in financial intermediaries. De (2003) has studied links between ownership and bank profitability, but has not found any systematic empirical effect of ownership on profitability. Governance in government owned financial intermediaries would raise several intricate issues regarding interests of the shareholders vs stakeholders when the sole or major shareholder (i e, government) is expected to act in the interest of the public at large. These could be areas for further work.

Notes

1 With opportunities for securitisation of loan portfolios even this distinction will go away. However, in project financing initial lenders may need to hold loans till projects are implemented and start generating cash flows.

2 Only in the case of NBFCs accepting public deposits requires to the issue of advertisements in newspapers soliciting acceptance/renewal of deposits from public.

References

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Diamond Douglas W, Rajan Raghuram G (1999): ‘Liquidity Risk, Liquidity Creation and Financial Fragality: A Theory of Banking’, National Bureau of Economic Research, Working Paper No 7430, Cambridge, December.

Holmstrum Bengt and Tirole Jean (1993): ‘Market Liquidity and Performance Monitoring’, Journal of Political Economy, 101(4) pp 678-709.

Jalan Bimal (2002): ‘Corporate Governance and Financial System: Some Issues’.

Liu Lawrence (2002): ‘Corporate Governance for Financial Institutions’, paper presented at Fourth Round Table on Capital Market Reform in Asia, Tokyo, April.

Macey J R and O’Hara M (2003): ‘The Corporate Governance of Banks’, Economic Policy Review, Fedral Reserve Bank of New York, April.

Rajan R and Zingales L (1998): ‘Power in a Theory of the Firm’, Quarterly Journal of Economics, 112 pp 387-432.

– (2000): ‘The Governance of the New Enterprise’ in Vives Xavier (ed) Corporate Governance: Theoretical and Empirical Perspectives, Cambridge, pp 201-27.

Shleifer Andrei and Vishny Robert W (1997): ‘A Survey of Corporate Governance’, Journal of Finance, LII (2), June, pp 737-83.

Takagi Shinji (2002): ‘Fostering Capital Markets in a Bank-Based Financial System: A Review of Major Conceptual Issues’, Asian Development Review, 19(1) pp 67-97.

Williamson Oliver E (1985): The Economic Institutions of Capitalism, Free Press, New York.
– (1996): The Mechanisms of Governance, Oxford University, New York

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