Hony.
Editor |
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Dr.
Bindi Mehta
(Director,
Research at ICSI - CCRT, Formerly, Chief economist, CRISIL
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URBAN
COOPERATIVE BANKS:
AVERTING MORAL HAZARD THROUGH CORPORATE GOVERNANCE
by
Dr. YRK Reddy
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The
serial disasters in the Urban Cooperative Banks are like
the formula-movies of Bollywood, showing yet again that
the Directors were not merely incompetent to deal with
risk and strategy but were actively involved in self-dealing
and connected lending. They thrived on conflicts of interests
such as, in the case of the Vasavi of Andhra Pradesh,
leasing premises built with Bank loans back to the Bank
at exorbitant rents. Employees, such as those of Vasavi
and Prudential of Andhra Pradesh, who have now taken to
the streets claim that they were victims of an unfair
entry duty of remitting a fee or a deposit and have been
demonstrating in front of the borrowers.
The mounting pressure, inter alia, from employees and
the depositors for quick action by the State Government
and the regulator including some sort of a bail out are
indicative of the ripening conditions for moral hazard.
It is the popular expectation that there will be pressures
on the State and the regulators not only in settling the
insurance for the small depositors and one-time settlements
for borrowers but also “help” the bigger borrowers in
sanitizing their own deposits! The action against the
guilty directors and borrowers is expected to be symbolic
in response to the public ire, which will peter out with
diminishing attention to the episode. In Andhra Pradesh
alone, one Chairman of the Bank is yet to be traced showing
the potential elusiveness of Veerappan, one bank has been
actively revived and the two recent ones have the potential
of beneficial treatment with the support of powerful policy
makers.
There are two critical infirmities in the UCB governance
that have been pointed from several quarters. Firstly,
the entry-level gate keeping does not use any validated
method of testing the vision, strategy, values and competence
of the promoting group and whether they are in tandem
with cooperative principles. The absence of a good screening
mechanism promotes rent-seeking conditions at political
as well as regulatory levels that encourage adventurers
to use them as an innovative route for raising finances
for pre-targeted lending.
Owing to the dominance of “entrepreneurship” over professionalism,
the Boards are obviously structured in such a way that
they thrive on low professionalism, low level of knowledge,
and expertise apart from exploiting the opportunity for
sleaze. With the result, the Urban Cooperative Bank appears
to be a special vehicle for enabling directors to indulge
in self dealing and connected lending that can move faster
if there are no roadblocks such as restrictions on borrowings
and active supervision and regulation. The choice of risk
portfolios, attraction of interest rate risks and incurrence
of unsustainable transaction cost are all mere corollary
to the absence of corporate governance which is critical
in this sector.
The entrepreneur-driven Urban Cooperative Banks appear
to thrive on two opportunities. One is the potential for
providing a low-profile conduit for moneys that can otherwise
be difficult to account for and the other being the insatiable
greed for higher rates of interest without appreciating
the associated risk. Thus, if the resource acquisition
policy is out-of-line with the principles of cooperative
movement, the lending strategy cannot be any better and
provides a good asset-liability policy match!
The conditions have been made more conducive with the
utter apathy of the members of the cooperative most of
who could any case be “connected” with the entrepreneurs.
Understandably, the deposits in this sector from non-members
exceed by far that of the members who would rather be
fleecing borrowers than greedy depositors.
Cooperative principles demand community orientation and
service to the members and purveying of credit to families,
businesses, and entities that are not traditionally served
by the large commercial banks. They are expected to involve
members democratically and ensure transparency of information
and transaction. They ought to get their deposits from
the community and the neighborhood with average rates
for services lower than the larger banks. These principles
are the heart of the cooperative movement and spurred
the growth of internationally acclaimed models in cooperative
banking. The Cooperative Bank Group in the U.K, the Credit
Group Agricole in France, Banque Coop in Switzerland,
OKO Bank in Finland have adopted strategies that made
them grow speedily serving special groups and needs and
adhering to the core principles germane to the cooperative
movement.
The second infirmity that may promote moral hazard is
related to the regulatory framework which remains unaddressed
with the Reserve Bank of India not in a position to supervise
and regulate this vast sector, the central government
not willing to let go of the control through the regulator,
the cooperative sector of the State not having the necessary
technical competence and the industry itself being divided
as to who should regulate and supervise. Moves for a separate
regulatory body with powers vested from the Central Govt,
the RBI and the States, which was mooted and reiterated
by the Governor of RBI, appears unacceptable to the States.
This regulatory overlap continues to provide the classic
scope for regulatory arbitrage for the players, and a
collateral scope for rent seeking, which is reflected
in several banks having started operating without a formal
approval by the RBI. Despite the distress conditions for
the entire sector, a huge number of UCBs have been registered
in the last one-year and a sympathetically high number
licensed by the regulator. The solution is no rocket-science,
either for the policy makers or the regulators, but is
dependent on the intention and will to follow the basic
principles inherent in corporate governance.
Policy level reform should focus on removing the scope
for regulatory arbitrage and strict “quality” processes
and measurements for entry, certifications, supervision
and compliance that can promote cooperative principles
and corporate governance. These processes are inherent
in the principles of corporate governance.
As Honorable Lord Thomas, Former ICA President commented,
Corporate Governance is more relevant to the cooperative
sector as it needs professionalism, transparency, independence,
as well as commitment. The federations must realize the
tenuous credibility this sector now has and bring out
codes and standards that improve the overall competence
in the Board, eliminate self-dealing/connected lending;
encourage member activism; improve reporting and transparency;
upgrade risk management. In the National Conference of
the Urban Cooperative Banks in July 2002, addressed by
Dy. Governor Shri Kamesam, it was agreed that the Directors
of the UCBs need training in appreciating the principles
of corporate governance as applicable to the sector and
for launching a concerted move to reform from within.
With over 200 Urban Cooperative Banks being weak, and
the continuation of symbolic actions, ritualistic burials
and “quick-fixing” as they tumble, the conditions for
moral hazard can only increase with hyper-competitive
politics that would generate the pressures for bailouts,
limited or large-scale. Even if the regulatory overlap
cannot be resolved shortly, there is discernible scope
for reform of the sector from within by generating quality
processes, standards and measures that will help in due
diligence on entry, board competence and independence,
transparency, disclosures, risk management and member
activism. As the sector is short of enlightenment of its
long-term self-interest, the regulator may activate the
process by specific actionable steps for building capacity
in corporate governance.
(Source:
The Financial Express, April 14, 2003)
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ROLE
OF FINANCIAL INSTITUTIONS (BANKING AND NON-BANKING)
IN PROMOTING CORPORATE GOVERNANCE
by
YRK Reddy
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A Synoptic Note of Presentation to the conference
on Corporate Governance for the Banking and Financial
Sector
at Malta on 18th September, 2000.
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1.0
Introduction:
1.1.
FIs can promote Corporate Governance in
their respective countries possibly in
three important ways. Firstly, by influencing
the government and the Central Bank so
as to create macro-conditions that would
lead to good governance and achievement
of overall socio-economic objectives.
The focus of their influence may be aimed
at achieving greater transparency and
openness (in budgets, prices, costs, subsidies
and overall information flows); greater
clarity in roles, responsibilities and
objectives of the State and its agencies
and accountability ( of people and agencies
responsible for the information, data
and omissions and commissions).
1.2. Secondly, FIs may need to initiate
a reform process within their Board structures
and procedures in conformity with the
general principles of good Corporate Governance.
These may include induction of independent
directors, separation of the Chairman
from the position of CEO, appointing board
sub-committees; better reporting and disclosures.
(Publicly listed Banks and NBFIs have
an immediate prospect of such a reform
so as to conform with the mandatory requirements
imposed by the Securities and Exchange
Board of India.) At present, the CACG
principles appear to be the most appropriate
to the developing countries considering
that they have adopted a more inclusive
approach.
1.3. The third manner of enhancing Corporate
Governance is in the realm of the corporate
clientele. This aspect has not received
as much attention as the first two and
is the central point in this presentation.
2.0. FIs and Corporate Clientele
2.1.
FIs by their nature of business get involved
with companies as lenders of finance and
also as their equity holders directly
or indirectly. There are two situations
of interface between the FIs and their
corporate stakeholders. The first is as
equity holders (ownership), and the second
as creditors (financial stakeholders ship).
These two roles are critical components
of Corporate Governance structure even
if conflicting at times. Traditionally,
there are four inter-related instruments
of Governance - Board of Directors, Market
for Control, Monitoring by Financial Institutions
and Debt. While the first two have been
discussed extensively, the latter two
have not attracted much debate. Debt becomes
important particularly during financial
distress. Thus, control by equity holders
is evident during good times. There is
often a shift in control in favour of
creditors during downturns in financial
health. Good governance requires active
monitoring by creditors - whether through
Board representation or otherwise. While
passive control has been merely through
collateral, active control requires evaluation
of the firms operations, decisions and
its capacity to repay. From the external
point, the government needs to support
the creditors by developing appropriate
legal and institutional framework to facilitate
information flow and debt recovery.
2.2. In India, financial institutions
have been equity holders in corporates
as promoters or as portfolio investors.
The equity holding FI is expected to play
an active role in the structure of Board
as also in exercising its rights during
the Shareholders meetings. (In the case
of Banks, there is a restriction on their
representation on the Boards of their
clientale which does not apply to NBFCs).
Even as a minority stakeholder, the bank
/ FI needs to decide as to its stand in
supporting or protesting against proposals
for Board appointments and other items
before the shareholder meetings. In this,
it may have an informal role, or a formal
one, of support to other equity holders
from the financial institution community.
An active stand by the FIs, would result
in putting adequate pressure for logic
in the selection of the board members/and
ensure that there are sufficient member
of fit, proper, competent and truly independent
directors.
2.3. The other role of Financial Institutions
is that of Creditor, which is more widespread
and also to some extent controversial.
The role of Banks and FIs as creditors
in the process of corporate lending, should
become a major policy debate on account
of two developments:
a)
The dominant role of debt in the emerging
economies and the increasing market for
debt instruments.
b) The controversy arising from the recommendations
of the CII code and the SEBI Committee
that financial institutions should not
have their nominees on the Boards merely
on the basis of their holding sizeable
securities in the company.
2.4. For a long time, Financial Institutions
have been adopting a passive mode of monitoring
their corporate clientele. This passive
mode entailed analysing the value of the
collateral more than the equity and operations
of the company. In fact, most credit decisions
so far have not reckoned the quality of
governance as a factor for evaluating
the proposals and their risks. If the
FIs have to be active in corporate governance,
they may need to adopt two important standards
at two different points in time. The first
is at the time of the decisions regarding
credit or equity stake, by evaluating
the governance structures and systems.
The second is in actively monitoring the
Board structures and appointments operations,
investment decisions and strategies of
the company either directly or in conjunction
with other creditors/equity holders. This
active stand requires policy decisions
in terms of coordination and lobbying
with voters and/or exercising voting rights.
2.5. At the macro-policy level, the three
crucial requirements for monitoring and
control by the creditors are:
a) Adequate information;
b) Market oriented incentives; and
c) Legal framework for debt collection.
2.6. Financial Institutions can become
change agents in economies to bring about
creditor discipline and as agents of good
governance. They can enhance the quality
of information flow from the borrower
companies. It is obvious that financial,
accounting, costing and pricing policies
can distort the information so as to overestimate
the value of the firm's assets. By insisting
on adequate quality information, the asymmetry
would be reduced. This also would lead
to better quality of information for the
regulator so as to control the risks of
non-performing assets.
2.7. In respect of market-oriented incentives,
the Government plays a crucial role in
aspects such as: recapitalisation of Banks
and FIs, trade credit incentives and the
like. The legal framework for debt collection,
again a Governmental initiative, has been
eminently addressed by the Narasimham
Committee report. The World Bank group
has also recognised the intimate connection
of Banks as creditors and the insider
behaviour among the corporates in given
macro-economic conditions. It noted that
the ability to discipline insider behaviour
gets restricted if the business environment
has few creditor protections, weak contract
enforcement, or unworkable bankruptcy
laws. It pointed to the increasing evidence
that corporate governance would be effective
only if the finance system enjoys good
governance - which would include the role
and responsibility of creditors.
3.0. Agenda for FIs in Promoting Corporate
Governance:
3.1. Evidently, there are two prominent
routes for FIs for enhancing Corporate Governance
among their corporate clientele. The first
is through incorporating CG principles in
the process of credit appraisals and due
diligence activities. The codes, principles
and best practices evolved may become the
bench-mark for FIs to evaluate the gaps.
It may be necessary for them to internally
validate the relevance of these principles,
codes, and best practices in improving the
actual quality of Corporate Governance,
share-holder value and sustainable advantage.
Such validation process will help in refining
the best practices and making them specific
to the context.
3.2. The other route is through active participation
in the shareholder meetings and where permitted,
the Boards. FIs may develop an internal
policy in this regard clarifying the purpose,
the conditions under which such representation
becomes necessary and the process. Selection
of proper candidates, their training, details
of the mechanism of briefing and de-briefing,
contingencies, collaboration/coordination
with other lenders/equity holders, performance
monitoring of the nominees, ensuring their
accountability would probably become part
of such a policy and its implementation.
Role of FIs in promoting C.G.
Through
Board Representation
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Through
appraisal / rating mechanisms |
- Internal
policy of FIs on when to seek
Board representation – Debt/Equity,
levels of exposure, other conditions.
-
Criteria for selection of nominee
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Training of Nominees
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Internal mechanisms of Briefing/De
Briefing.
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Mechanism of coordination with
other Institutions
Evaluation of nominees performance
in Board and shareholder meetings
including contribution to enhancing
C.G best practices.
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- System
of factoring in C.G. variables
in appraisals, due diligence etc.
- Establishing
the validity of the assumption
that a particular type of C.G.
structure/practice will result
in lower risk/higher shareholder
value, sustainable advantage.
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CORPORATE
GOVERNANCE RATING - GOING TO PARTY IN A BIKINI?
by
Dr. YRK Reddy
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(Published article in the Financial Express, March 10,
2003)
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The
continuing efforts to develop capital markets and the
new ones to bolster investor confidence have created a
market for rating corporate governance. The cynic would
say that it is probably the same as the market for rituals
that goes up with sinning. We should hope that rating
of corporate governance would not decline to be a prosaic
ritual or a mesmerizing voodoo to propitiate the reputation
agents in the capital markets. To ensure that cynics will
not win this argument, there is need to understand the
challenges than fall prey to fashions arising from assertions
in place of validation.
The need for validation arises afresh in the context of
the Securities and Exchange Commission’s new enquiry into
the failure of rating agencies to spot the impending collapse
of corporates. As the Economist recently pointed out:
“The SEC hearings are focusing partly on criticism that
the rating agencies are venturing into territories for
which they are ill-equipped and where they are able to
add little or no value. The agencies’ traditional role
of rating debt securities has been stretched to cover
a growing list of exotic instruments dreamt up by investment
banks, including such things as collateralized debt obligations,
which are a way of taking a bundle of credit risks and
slicing them into layers that carry different levels of
risk”.
While the Enron et al episodes point to laxity, there
are others who accuse them of causing collapses through
ultra-conservativism. It is reported that several French
companies have been accusing rating agencies of being
“pyromaniac” fireman, in the words of Alcatels, CEO, Serge
Tchurak while Vivendi universal Boss Rene Fourtou called
them “executioners”. Either case, there is indeed pressure
for greater oversight over the rating agencies to make
them more accountable.
Though Corporate Governance is a relatively unknown territory
and a “white space”, several are rushing into this. Standard
& Poor has taken the lead in creating a new service
it calls as Corporate Governance Scores. Dominor has been
doing the same from Belgium. There is a Scorecard in Germany
by the DVFA. The Japanese - patience be with them – have
been doing some good research to validate the models before
jumping into new fashion. ( Our own ICRA has made a courageous
move into this relatively under-researched field and awarded
a creditable number to ITC Ltd.Since then, CRISIL has
developed a service line called Governance and Value Creation
(GVC) ratings and awarded the top Grades to HDFC, Hero
Honda and HDFC Bank and a high CRISIL GVC Level 2 for
Dabur.)
The
service line developed by S&P is well documented and
elaborate addressing the needs of the financial stakeholders;
equity and debt. It has detailed criteria for the Country
Ratings as well as the Company’s, though it is now looking
at the company ratings only that would help institutional
investors. Apart from the overall score for the company,
individual rating is available for the four components:
Ownership Structure; Financial Stake-holder Relations;
Financial Transparency and Information Disclosure; and
Board Structure & Process. The scores, which range
from 1-10 have three broad bands. A rating of 7-10 is
for those companies, which have acceptable global standards.
The S & P and all other rating models appear to have
been developed based on the assumptions about markets
and the principles supporting them. They have been fashioned
mostly after the principles developed by the OECD, which
apparently did not have rating as an agenda. The OECD
principles developed by an ad hoc task force, in 1999
are aimed at developing international capital markets
with particular emphasis on equal treatment of shareholders
and transparency through disclosures. These principles
themselves are likely to be revised soon.
Several companies in the emerging markets and transitional
economies that have used this service have made the report
publicly available, which is creditable and underscores
the principle of transparency. Such a lot includes the
Russian company, Investment Banking Corporation which
was rated a low of 4.2 with several holes in the governance
system and which has since been revised downwards to a
bare 4.0 a few weeks ago. Deminor of Belgium uses a different
Euro-sensitive rating which its clients such as Suez proudly
reveal.
Rating
corporate governance is serious business as it is like
the traffic signal at cross roads. Institutional investors,
financial institutions, employees and small investors
will get guided by it even if the intention is probably
only to serve as a guide. Obviously rating is mere opinion
than surety. It may even come with loads of caveats. But
if there is confusion in the objectives, laxity in the
methodology and lack of transparency in communications
it can well be used as “aqua” advertising for liquor or
race sponsoring for cigarettes. It can result in extra
burden, if not a liability or risk, for the regulators
to prove their pro-activeness in overseeing the rating
agencies. That the traffic signals are not being operated
by novices.
There are three major challenges facing corporate governance
ratings in India. Firstly, the CG ratings do not yet have
a clear objective in relation to capital markets – either
debt or equity. Are they a “credit passport” for lenders
to inspect? Are they a “chastity belt” that potential
employees, directors, and stakeholders want to see before
being engaged? Are they an insurance for the investors
against sleepless nights?
The reason for the relative success of credit ratings
arises from the clarity of objectives for the rating agencies,
the rated companies, and the public dealing with the company
on the one hand and, on the other, the wealth of knowledge
base created over the years. It is for this reason that
rating agencies like Moody`s have an interesting track
record over the decades that shows that the lower the
rating and the longer the holding period, the higher has
been the default rates. For instance, in the USA, the
default rate on bonds rated Aaa has been extremely low
with only 0.1 percent issuers on average having defaulted
within five years and 1.0 per cent over ten year period.
In contrast, B rated issuers had a correspondence default
rates of 28.0 percent and 40.0 percent.
The second challenge, which is implicit in the above,
is that there is insufficient accumulated knowledge on
corporate governance and a great amount of fluidity in
the theory at present. In this context it is noteworthy
that the MD of ICRA has reportedly admitted “that assigning
corporate governance ratings is still very much a learning
process for his organization” ( Subir Roy, in Economic
Times). There is inadequate research and validation on
what constitute good corporate governance that provides
for synergy for financial performance. In the absence
of the solid base of knowledge and statistics associated
with rating of debt instruments, corporate governance
is currently a minefield of assumptions. A worthy speculation
will be to apply the current models of corporate governance
ratings to companies that have defaulted and / or collapsed
over the years from among the top 500 companies of the
1990. Major airlines, electronic giants, and conglomerates
may pass the grade in corporate governance and yet collapsed.
A further speculation would be to imagine how easy it
is to reverse engineer the structures and processes to
suit the rating models without commensurate change in
the intent or content. One could draw lessons from the
ISO certification to see how several companies have been
able to meet the norms of the manuals and processes without
actually forsaking the flexibilities and discretions they
preferred to enjoy at the cost of the customer and the
share holders.
The third challenge for rating arises from the weights
to be given to companies in the context of global market
and foreign institutional investments. The international
corporate governance ratings reckon the country situation
as well. If a company has good corporate governance ratings
and yet the country’s system of enforcing legal rights
is weak or the legal system is perceived as inefficient
or corrupt the overall rating suffers. It would be “like
valuing a beautiful house located in the congested old
city”. There would be need for greater clarity and transparency
as to where, how and to what extent and under what conditions
will the Indian agencies apply or not apply the country
ratings when rating a company.
Given these challenges, it may be more appropriate to
encourage companies to use templates that would help them
rate themselves on the one hand and let financial institutions
and banks also use them to motivate internal development
of Boards, systems, and practices that may conform to
best practices. Such a move may prevent a hasty introduction
of a rating mechanism that seems like going to a party
in a bikini.
Eventually, it is a belief in corporate governance that
would improve the quality of the company’s functioning
than the certification. This is amply clear in the case
of the quality movement and ISO certification where a
passion for quality and internal aspirations have become
more important than certifications aimed at manipulating
perceptions.
Yaga Consulting Pvt. Ltd. has developed an instrument
for the use of the Academy of Corporate Governance, which
does a Beta test for Corporates to be able to analyze
the gaps and move towards better corporate governance.
This instrument, which has been pre-tested with the Thais,
Malaysians and the Indonesians, helps in corporate governance
development of companies with no further objectives than
that. This middle path may be more appropriate than the
potential risk associated with the rating mechanism with
insufficient research, validation, and clarity.
(Source: The Financial Express, March 10, 2003)
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