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1. Prologue: Just a few years ago there were
apprehensions whether the banking and financial sector
needs any special attention at all in the context of corporate
governance. I recall, with satisfaction, the pioneering
effort we at the Commonwealth/CACG made in establishing
the rationale for particular attention to financial sector
governance, commencing with the addresses to Central Bank
Governors in London, followed by similar efforts in Nairobi
and Malta and the draft report made by our Advisory Group
on Corporate Governance in Banking and Finance and the
report we made on the review of OECD principles emphasizing
the particular challenges of the developing countries
and small States. We had looked at not merely the macro
aspects relating to corporate governance in this sector
but also from specific angles such as corporate credit,
retail products, public enterprise banks, insurance, non-banking
financial companies, credit unions and the like. We had
done similar pioneering work in the context of Public
Enterprises even as a unitary market-centric perspective
that assumed wholesale privatization was being aggressively
propagated. It is indeed heartening to note that several
multilateral organizations as well as academia are now
coming to see our reason, even if many are shy of acknowledging
the source of their idea, to now debate corporate governance
issues relating to the financial sector and the public
enterprises. I learnt that OECD had last month convened
a round-table with public enterprise agenda – for the
first time. I do hope we will go a step further in documenting
better and contributing further to the skeletal body-of-knowledge
in corporate governance.
2. Introduction:
2.1 This paper approaches the topic by (a) recapitulating
the criticality of corporate governance in the finance
sector; (b) raising select issues on dynamics of the control
architectures/and institutional mechanisms in this sector
and (c) discussing macro approaches to address the challenges,
particularly relating to resolution of conflicts of interests
(which are like geological fault-lines/fractures that
cause earthquakes). The paper keeps in mind the context
of developing countries in the Commonwealth region that
CACG is particularly concerned with but restricts its
focus to the macro-aspects than the Board and shareholder
issues, which have been well covered in our earlier conferences.
2.2 The paper deals with financial institutions at large
but addresses the banking sector more due to its significance
for the developing countries. Financial institutions can
be recognized by various characteristics. One typology
is to classify them by the nature of services provided
by them. They broadly provide a range of services such
as “payments services, liquidity, divisibility, maturity
transformation, store of value, information economies
and risk pooling” (Financial System Inquiry, 1997). They
are often provided in some combination or the other. They
may be classified as deposit taking institutions (banks,
building societies, credit unions, etc); risk pooling
institutions (such as life and non-life insurance companies);
contractual savings institutions (such as mutual funds
– income, growth, tax-exempt, sectoral, hedge or cross-border
funds); market makers (investment companies, stockbrokers
and other securities dealers); specialized sectoral financiers
(leasing companies, real estate financiers) and financial
service providers (such as advisors, credit rating agencies,
equity research, etc).
3. Criticality of corporate governance for the
finance sector:
3.1 The crises in Argentina, Russia, and Turkey which
followed the Asian Financial crisis have proved how increasingly
sensitive and volatile the financial sector can be. The
unending research on the causes of these crises have indicated
the coexistence of (if not causation by) poor governance
structures and systems contributing to lack of transparency
and exploitation of conflicts of interest. Corporate governance
in this sector has assumed importance at public policy
level due to the increasing possibilities of systemic
risks and a contagion that may transcend classes of institutions
(both sectorally and geographically). The tasks before
the GFSF and the debates on global financial architecture
have significant influence on the evolving corporate governance
architecture around the world.
3.2
Governance in this sector is known to pose a special problem
due to three other reasons. Firstly, the activities of
financial institutions are opaque, particularly in the
banking sector. Unlike in the product and other services
markets the exchange is not immediate and discernable
but a promise to pay in the future (in contrast, one would
know straight away if the Hamburger was stale or the massage
lousy). Further, what appears to be a reasonably acceptable
situation can change over night as one has noticed in
the case of the rogue traders of Barings or Sumitomo Corporation
or those left holding the can after the collapse of major
corporations in the US as well as the Commonwealth. The
problem of opacity and dynamically shifting risk profiles
may be lesser in some types of financial institutions
such as the credit rating agencies but exists in varying
degrees in pension funds, investment funds, and insurance
companies as well. Opacity is not merely the result of
poor disclosures but mainly due to the nature of contracts
whose risk-return profiles vary with each proposal, for
most of the assets.
3.3
Secondly, most of the assets are relatively illiquid and
the asset-liability mismatch can be triggered even by
irrational panic (particularly in the event of contagion
or a risky portfolio on either side.)
3.4
Thirdly, there are serious informational asymmetries which
get aggravated with the coordination issues among equity
and debt holders that in turn intensify the agency problem.
The equity and debt holders find it difficult to overcome
the informational asymmetry between the insiders and outsiders
and also to coordinate among themselves – monitoring/control
by this mechanism, especially in the context of small
investors and depositors, becomes an impossible task,
and most resort to free-riding.
3.5
It is because of the acute problems relating to the opacity,
illiquidity, informational asymmetry, and the consequent
aggravation of the agency problem that regulation becomes
an important public policy instrument to ensure that the
insiders do not exploit investors, customers and the government.
The role of the regulator, its independence, and governance
issues become an area of special attention because of
this.
4.
The Control Architecture:
4.1
In my view, the quality of corporate governance is a function
of the quality of the overall control architecture. Control
architecture may be defined as a framework or grid that
provokes and canalizes behaviors of various players within
the system.
4.2
The framework consists of regulators, government, institutions
such as stock exchanges, judiciary, enforcement agencies,
shareholders meetings, and the Boards i.e.: all those
that determine the macro-conditions relative to regulation,
legal infrastructure, informational infrastructure, and
market infrastructure as well as the bodies implicit in
law relating to joint stock companies. There is no uniquely
good control architecture, despite the popular conception
of the “outsider” / market model advanced by researchers
particularly of the World Bank, Harvard and the OECD –
this will indeed be borne out in the years to come. At
the same time, there is no other robust framework that
can be used as an international standard. Thus, the control
architecture has to be uniquely adapted to the economic
and developmental contexts of the country and steered
gradually and sensitively.
4.3 Corporate governance literature has popularly advocated
the benefits of private ownership of financial institutions
and how government ownership can induce inefficiency,
inappropriate / subsidized lending; conflicts of interest
between the bureaucrats and the managers; conflicts of
interest between the regulators and the regulated; abuse
of office; and corruption. Research is being cited to
show as to how government ownership weakens incentives
and curtails competition while tolerating inefficient
government directives as well as political patronage.
There have been references to the possible linkages between
the banks/developmental financial institutions/insurance
companies/investment funds and lending to state-controlled
companies for commercially unsound reasons. In my view,
several countries may not yet have adequate capacity to
fully absorb the massive government stake at fair value
in a short span. Further, there are large tracts of the
economy whose needs can never be served by applying the
principles of private sector incentives. Directed lending
for public policy reasons are often implemented by the
government controlled financial institutions larger interests
of complex economies. In fact the MDG can only be achieved
by relying on such dirigisme. Recalling the comparison
to circulatory system in the body, if finance does not
reach all these tracts through private effort, the government
or the regulator may indeed have to take a highly intrusive
and directing role which again trades-off negatively with
the space for “private sector”.
4.4
In this context, there has been a debate in India over
apprehended stringent regulatory restrictions on concentration
of ownership; entry, takeovers, crossholdings, and the
like in private banks. While one view is that such regulation
is intrusive and curtails competition particularly enabling
the MNCs, the other view is that perfectly competitive
conditions are far away in developing countries and the
potential risks will have to be mitigated by such regulatory
measures, at least till such time that markets are able
to graduate incrementally. If the market is unable to
exercise control, obviously the regulator must fill that
void. Soft regulation amidst weak market conditions invites
exploitation by the insiders. (Thus, in the case of Indonesia,
it is estimated that 85-345 per cent of capital was lent
to insiders in the process of systematic loot. Research
has also shown that in Mexico nearly 20 percent of total
loans go to parties connected with the bank and such parties
enjoyed lower interest rates, longer maturities, substandard
collateral, and poor recovery efforts.)
4.5
In the developing countries, “contestability” is exercised
more by the regulator than the market - not because of
opacity and informational problems but due to insufficient
development of the domestic market for control. The number
of potential predators is very few, the transaction cost
is high and the process is also time consuming. Though
the market for control may be better in the case of non-banking
finance companies and even the banking companies in some
countries, it is indeed highly concentrated in the case
of pension and insurance companies and it would take several
decades to develop such markets in these. Because of the
structures of the markets and their nascence, competition
is as yet an ineffective mechanism in the control architecture
– unless it is thrown open for global players which in
effect will snuff out competition eventually in other
ways.
4.6
On the other hand, regulation may continue to be the most
important instrument in this architecture both for good
governance as well as gradual development of other mechanisms
such as competition. As perfect competition and perfect
markets are indeed utopian for the developing countries,
it becomes axiomatic for regulators to manage the architecture
of controls in such a manner that markets develop robustly
and naturally. (It would be good to refer to the story
of the caterpillar that was helped to metamorphose as
a butterfly – hasty intervention ended up having a crippled
butterfly.)
4.7
In the context of corporate governance among banks, there
is invariable reference to the moral hazard connected
with deposit insurance and that it tends to adversely
affect the size of the capital and also increase the risk
for bank assets. In my view, the argument against deposit
insurance presupposes the conditions of full flow of information,
literate and educated citizens who can use such data to
make informed decisions, and well developed institutional
intermediaries such as the media and research analysts.
If the mass of depositors do not have either easy access
or the capacity to make informed decisions as in the case
of several developing countries, the advocacy against
deposit insurance will be akin to Mary Antoinette’s insulated
thinking to suggest cakes for the hungry. In fact, in
most developing countries majority of the depositors do
not even know the existence and conditions of such insurance.
Elimination or reduction of deposit insurance may not
change the risk shifting behaviors of management nor assure
the exchequer that there will indeed be no bail-out. (If
Chrysler could be bailed out with public money in the
US, small depositors will threaten mass suicide if they
are not bailed out in a poor country.)
4.8
Thus, the popular conclusion that government must support
private including self-regulating sector entities to monitor
financial institutions; support the private sector and
market participants than regulate; reduce government ownership;
allow foreign entities without restrictions; reduce/eliminate
deposit insurance; improve the market for corporate control
especially by encouraging foreign banks as a direct mechanism
for creating competitive pressures, etc. (see the works
of Barth, Capiro and Levine; Clarke and others and other
World Bank publications) need to be contextually analyzed
and accepted. The conditions in most developing economies
are such that the control architecture needs to be strengthened
incrementally to avoid sudden shocks of shifting to market
based mechanisms.
5.
Corporate Governance Challenges:
5.1
The major challenge for the entire sector surrounds two
critical attributes that need to be dynamically instilled
into the system. The first is to improve transparency
and free flow of information and the second relates to
establishing structures, processes, and standards by which
conflicts of interest are meaningfully managed.
5.2
The steps for improving information flow, transparency,
and reporting have been taken both at the multilateral
as well as at the professional levels. The IMF’s Transparency
Codes have given the broad approach for policy makers
in terms of monetary policies, and financial policies.
The efforts at the BIS/BCBS, International Organization
of Securities Commission (IOSCO), International Association
of Insurance Supervisors (IAIS), Institutes of Company
Secretaries and Chartered Accountants are particularly
noteworthy for establishing benchmarks and standards for
the countries to follow. The assessment programmes such
as the Report on Standards and Codes (ROSC) of the World
Bank and findings of the Financial Sector Assessment programme
have become important motivators to nudge the countries
to meet the international expectations.
5.3
While these moves have contributed to better regulation
and transparency, the area of concern is the motivation
among people to use data/information and exercise democratic
rights actively as an effective mechanism of governance.
Economic assumptions stop with the hope that once the
information is made available, market forces respond uniformly
and adequately. This indeed is flawed, in my view, particularly
in the case of countries which have low capacity on the
one hand and higher reliance on reputation and trust with
high propensity for free-riding (laced with a dash of
Karma philosophy).
5.4
The other challenge has been to sensitize and manage conflicts
of interest which have particular importance in the financial
sector. For reasons of opacity, informational asymmetry
and aggravated agency issues, the scope for profiteering
from conflicts of interest are enormous. Conflicts of
interest in the financial services sector have been recognized
particularly in four areas i.e. “underwriting and research
in investment banking; auditing and consulting in accounting
firms; credit assessment and consulting in rating agencies;
and universal banking” (Andrew Crockett and others, 2004).
Conflicts of interests has been defined in the above work:
“Conflicts of interest arise when a financial service
provider, or an agent within such a service provider,
has multiple interest which create incentives to act in
such a way as to misuse or conceal information needed
for the effective functioning of financial markets”. It
is well recognized that conflicts of interest cannot fully
be eliminated.
5.5
On the other hand, there are some situations where conflicts
of interest actually lead to economics of scope that brings
about greater efficiency, reduced transactions cost, and
welfare so long as they do not adversely affect other
market participants. Thus, the policies for mitigating
the ill effects of conflicts of interest must evaluate
if such initiatives will actually result in reduction
in welfare than its promotion, in the given situation.
5.6
Broadly, however, conflicts of interest in the case of
universal banking have been resolved in the United States
several decades ago which is being followed in the other
countries as well by separating investment banking from
commercial activity. Regulators have come to recognize
and examine closely the conflicts of interest in other
areas such as insurance and banking; banking and capital
market activities; ownership in different banks/financial
institutions; and the like. In the case of the rating
agencies, conflicts of interest arising from their consulting
activities have been less apparent. The hope is that the
rating agencies would exercise caution as excessive exploitation
of the conflicts of interest may lead to reputational
risk (the blatant exploitation of a similar condition
is in the case of quality certification/accreditation
companies which also render indirect consulting for establishing
the quality systems, policies and manuals – they have
so far escaped the reputational hazard).
5.7
Enron has caused a new wave of concern relating to the
conflicts of interest between the auditors who also render
consulting services. It has been some years since companies
have been segregating their consulting businesses from
auditing and also disclosing the distribution of fee between
auditing and accounting, management advisory, and tax
related services. In the year 2002, the big four companies
earned more fee in management advisory and taxation services
than from auditing and accounting. It is noteworthy that
following the collapse of Enron and Arthur Anderson consulting,
the fee on account of auditing and accounting has grown
both in absolute and percentage terms. It is a matter
of speculation whether this was an organic growth or whether
there was cross billing. Despite several of the auditing
firms spinning of management advisory services, the general
feeling is that the separation is greater in form than
in substance.
5.8
In the case of investment companies, conflict of interest
has been particularly between underwriting and research
which becomes noticeable during periods of IPO boom when
there is irrational exuberance among the public to subscribe
on the basis of self-serving research and advice. Some
stock exchange initiatives have come out with a mixture
of disclosure, separation, and prudential supervision
as an answer. The conflicts in this field continue to
be covert and well exploited in most of the developing
countries.
5.9
Broadly, conflict of interest in the financial sector
are sought to be mitigated by using five generic approaches:
market discipline; mandatory disclosure for increased
transparency; supervisory oversight; separation by function
and, socialization of information. Andrew Crockett and
others recommend the following nine as remedies for managing
conflicts of interest in the financial services industry.
-
Increase disclosure for investment analyst, credit rating
analyst, and auditors to reveal any interest they have
in the firms they analyze;
-
Improve corporate governance to control conflicts of
interest, ensuring that auditors are responsible to
shareholders and not managers;
-
Increased supervisory oversight over conflicts of interest;
-
Provide adequate resources to supervisors to monitor
conflicts of interest;
-
Establish best practices, codes of conduct to control
conflicts of interest, devised by industry and supervisors
in cooperation;
-
Enhance competitiveness in the rating agency industry;
-
Prevent cooption of private information producing agents
by regulators and supervisors;
-
Avoid the forced separation of financial service activities
except in unusual circumstances;
-
Avoid the socialization of information in the financial
service industry in most circumstances.
5.10
There are other conflicts of interest such as the following
that need close examination particularly in the context
of developing countries.
- Conflicts
among asset management companies, trustees, research/advisory
service providers, and clients (this has escaped regulatory
attention for long).
-
Conflicts of interest within the insurance companies
(opacity in insurance companies is reportedly higher
which attracts exploitation of conflicts of interest
more than in banking. Economist had carried an interesting
perspective in analyzing the risk transfer by banks
that had lent to Enron).
-
Conflicts of interest among directors that lead to connected
lending, self dealing, related party transactions, etc
(the paradox in the urban cooperative banks/credit unions
is yet to be resolved satisfactorily in many countries).
-
Ownership of equity by regulators and employment of
regulators by private sector (“Amakudari” in Japan that
led to unsafe banking).
-
Conflicts of interest between Government, bureaucracy
and regulators (regulators independence and governance
of regulatory bodies has been an issue among several
developing countries).
5.11
There are regulatory overlaps/gaps as also laws that do
not support the popular expectations for good corporate
governance. These, may accentuate conflicts of interest,
regulatory arbitrage and exploitation of legal lacunae
to perpetuate poor standards of governance. In sum, conflict
of interest cannot be eliminated fully. However, proactive
measures by the government and regulators by establishing
norms for separation of functions/activities; supervisory
oversight and mandatory disclosure are probably more appropriate
for the developing economies which cannot as yet hope
for market imposed discipline.
6. Conclusion:
6.1 In conclusion, the financial sector is probably amongst
the fastest growing segments of most economies. Because
of the very nature of the industry, special attention
is warranted for improving corporate governance not merely
for domestic efficiency and better flow of international
finance but also to avert contagion effects and systemic
risks. The opacity, illiquidity, informational asymmetry,
and coordination problems aggravate the agency issue in
this sector thus calling for substantial regulation and
supervision. The control architecture prescribed and supported
by several multilateral organizations appears to bank
on market oriented mechanisms to resolve the governance
issues. They hope that private sector enterprise, its
growth, and monitoring are more appropriate and efficient
compared to government control, ownership, regulation,
and supervision. They also believe that the presence of
foreign institutions particularly improve competition,
transparency, and also reduce corruption. The challenge
for the developing countries, on the other hand, is that
the markets are not yet developed sufficiently to have
enough number of domestic players to give meaning to a
competitive market.
6.2
Further, most of the public does not have the capacity
to use the information generated and exercise control,
either as depositors or as equity holders. If the financial
system is akin to the circulatory system of the body,
finance has to reach all parts of the economy. Unfortunately,
several sections/tracts of developing countries are just
not viable propositions for private banking or other financial
services. It will be generations before the private sector
and the market forces are able to find incentives for
servicing these segments. Till such time as markets develop
with potential institutions, good number of domestic predators,
and other competitive forces, corporate governance must
continue to use regulation and supervision as a dominant
mechanism for corporate governance. Indeed, they have
to be relied upon as the agencies to gradually develop
the markets and the competitive forces along with the
necessary macro conditions relating to legal infrastructure,
information infrastructure, and market infrastructure.
6.3
Corporate governance challenges for the financial sector
revolve around two key aspects i.e., information flow,
and conflicts of interest. While the efforts of the multilateral
and international organizations are very helpful in establishing
the quality structure and flow of information, the challenge
for developing countries continues to be one of capacity
to use this information meaningfully. At the same time,
conflicts of interest exist particularly in four areas
and these can be resolved through a combination of approaches.
Of these, it is probable that developing countries will
have to continue to rely on structural separation of functions
and activities; supervisory oversight; and mandatory disclosures
in that order of priority, as market discipline is still
a distant possibility.
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