Financial Standards and Codes: Report of Advisory Group on Banking Supervision

Corporate Governance

The OECD has defined corporate governance as involving "a set of relationships between a company’s management, its board, it shareholders, and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and shareholders and should facilitate effective monitoring, thereby encouraging firms to use resources efficiently.

Corporate governance in banks assumes importance in view of the critical role of banks in any economy as financial intermediaries, repositories of vast credit-related information and as part of the payments system. The existence of sound corporate governance in banking organisations is fundamental to their own sound functioning and to the stability of the banking system as a whole. No amount of controls, systems and regulation can be a replacement for sound corporate governance. At its best, sound corporate governance in banks almost takes on a role akin to that of an efficient, well-informed and detached supervisory authority thereby facilitating sound banking supervision

The BCBS has defined corporate governance, from a banking industry perspective, as involving "the manner in which the business and affairs of individual institutions are governed by their boards of directors and senior management, affecting how banks:

• set corporate objectives (including generating economic returns to owners);

• run the day-to-day operations of the business;

• 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

• protect the interests of depositors."

While several basic standards put forward earlier by the BCBS had referred to corporate governance in some context or the other, a comprehensive set of standards focusing on corporate governance was set out by it in the paper on Enhancing Corporate Governance in Banking Organisations (September 1999). The paper, while reiterating the issues raised earlier, emphasises the importance of the OECD principles for banks. The Group has tried to evaluate the current status on corporate governance in banks in India against the international standards and codes as set out in the BCBS paper. The evaluation of the Group and its suggestions on those areas where compliance is not up to the best international standards have been presented in Annex 2. The main points arising there from are discussed in the following paragraphs.

The Group, while recognising that banks and financial institutions are of various types, constituted under different statutory provisions, feels that the nature of a bank’s ownership is not a critical factor in establishing sound corporate governance practices. The quality of corporate governance should be the same in all types of banking organisations irrespective of the nature of their ownership. Thus, the sound practices for corporate governance apply in equal measure, if not more, to government owned banks also which dominate the Indian banking scene. Since the depth and extent of compliance of the standards of corporate governance may vary from bank to bank, within an overall generalised level, it is desirable that all banks meet a certain benchmark level representing an acceptable standard of corporate governance. From this level, there will have to be a sustained progress towards best international standards, the achievement of which within a reasonable timeframe will be targeted.

The banks need to follow the best practices in respect of constitution and functioning of the boards. It is, therefore, suggested that the process of induction of directors into banks’ boards and their initial orientation may be streamlined. The boards of banks do not seem to subject themselves to any measure of accountability or performance either set by themselves voluntarily or made applicable to them externally. This leaves them, largely, without any accountability either to the institution itself or to the supervisor. This situation calls for correction.

Though selection for nomination of individuals on banks’ boards is on the basis of his/her qualification considered suitable for the position, there is no practice of pre-induction meeting/briefing or any post-induction orientation. As such, often a proper appreciation of their role in banks’ corporate governance takes time to develop. A system of pre-induction meetings as well as post-induction orientation for the newly appointed directors on the boards of banks needs to be introduced.

Good governance requires that boards establish strategic objectives and a set of corporate values that are communicated throughout the organisation. These are often not defined by the boards very clearly and their communication throughout the organisation is quite uneven. Long-term problems and hindrances in the way of achieving organisational goals tend to receive attention only at higher levels of management. Banks need to develop mechanisms which can help them ensure percolation of their strategic objectives and corporate values throughout the organisation.

Boards need to set and enforce clear lines of responsibility and accountability for themselves as well as the senior management and throughout the organisation. However, boards of directors in very few banks are known to enforce clear lines of responsibility and accountability for themselves. In quite a few cases, there is not enough clarity about their roles. Much of this is because of the manner in which the boards are constituted. There is an urgent need to follow the internationally acknowledged best practices in banks in respect of constitution and functioning of boards.

Members of Board of Directors are required to give their valuable time to the governance of banks. In this context, there is a need to have a definite ceiling on the number of boards and the number of Committees a director can work in at a time.

The boards of banks are required to form Committees for risk management, audit, compensation, nomination, etc. The Audit Committees in banks are quite well established in discharging their functions. Introduction of systems for risk management in Indian banks is however rather recent and so are the risk management committees of the board. While it would be practicable for big banks to put in place independent and effective risk management systems and processes, smaller banks lack the expertise in this area and, therefore, will have to be given special attention by way of encouragement as well as technical support so that they can imbibe risk management practices in as short a time as possible. A timeframe of two to three years is considered adequate for the purpose.

Save in a few small private sector banks, remuneration of employees is not linked to their performance. In the public sector banks, which account for more than 80 per cent of the country’s banking sector, remuneration has so far been fixed at the industry level with the approval of the Government of India. In such a situation, there is hardly any room for linkage between individual performance and remuneration. For understandable reasons, therefore, public sector banks do not have a remuneration committee of the board. There is a need to review the current practice and link remuneration with performance.

It is desirable that performance measurement, currently confined mostly to operating units, e.g., branches, is extended to individuals and a linkage between performance and remuneration/reward is established. It should be possible to do so even in the public sector banks if a consensus can be achieved between the unions and the management on converting the present flat and unrelated to performance remuneration structure prevalent in most banks into a performance-related remuneration structure. There is an urgent need to review the current practice and link performance with remuneration. Compensation Committees could be set up under the new arrangement.

Nomination Committees are expected to assess the effectiveness of the board and direct the process of renewing and replacing board members. As of now, there are no such committees except in the case of some private sector banks. There is also no established system to assess the effectiveness of the functioning of the board members. Such Committees and assessments would be desirable. The present system of nomination of directors on the boards of banks is neither appropriate nor effective in the entirely changed environment and is, therefore, expendable. Nomination Committees of the boards should be formed and allowed to function freely.

The current standards of transparency would need to be raised. A fair beginning has been made in this regard but the approach of the banks and the applicable accounting standards will have to be changed for achieving greater transparency in banking operations and accounting. Public disclosure is desirable in the areas of structure of the board and senior management, basic organisational structure, incentive structure and the nature and extent of transactions with affiliated and related parties. Though the structure of the board is normally revealed in the balance sheets of banks, details of committees of the board, and the qualifications of the directors are not always available publicly. Disclosures in respect of this and the other aspects mentioned above need to be encouraged.

Transactions with affiliated and related parties are not disclosed in the balance sheets of banks. All such information should be available in the public domain. Further, though Section 20 of the Banking Regulation Act, 1949, prohibits loans and advances to directors and their connected parties, there is no statutory restriction on dealings with large shareholders. A provision on the lines of Section 20 of the Banking Regulation Act, 1949, on connected lending will have to be made in respect of large shareholders and a clear definition of large shareholding would need to be provided.

Because of Reserve Bank of India/Government ownership of banks (in the public sector), there is some overlap in the role of the Reserve Bank of India as owner/owner’s representative and as the regulator/supervisor. This overlap needs to be corrected so that Reserve Bank of India can perform its regulatory/supervisory role without any hindrance/conflict of interest.

Government ownership of banks is not conducive to any serious and urgent corrective action by the regulator against any one of them. The limitations of the legal process have also come in the way even where corrective action like removal of management not found to be 'fit and proper' was contemplated.

Banks in India have in place a fairly robust framework for corporate governance in which modern practices of sound corporate governance can be incorporated and built up to further the interests of the individual banks and all the stakeholders. Thus, banks articulate corporate values, codes of conduct and standards of appropriate behaviour, etc., and have systems to ensure compliance with them. Banks also have well articulated corporate strategies decided by their boards. In pursuance thereof, performance budgeting system is followed, which measures, monitors and evaluates corporate success and the contribution of business units. Banks have clear delegation of powers to different levels of hierarchy for financial and non-financial sanctions. The mechanism for interaction and cooperation among the board of directors, senior management and the auditors is fairly established.

Either on their own or under the guidance of RBI, most banks have put in place processes designed to monitor performance and fulfilment of duties and responsibilities at different levels. RBI checks the governance practices at banks and brings to the management’s attention problems identified by it. It also emphasises accountability and transparency in banks, ensures that banks’ organisational structure provides for proper checks and balances, and proactively guides banks on sound corporate governance practices. The organisational structure of banks enables adequate oversight by their boards. The present system of control and audit in banks enables such oversight. Systems are in place which enable direct line supervision of different business areas.

The directors do not interfere in day-to-day management of banks. While loans and advances to directors or to related individuals and bodies are prohibited by law, disclosure of interest by directors is mandatory. In case there is any likelihood of conflict of interest arising, the concerned director is required to abstain from participating in the decision making process relating to that case.

The importance and independence of internal as well as external audit is well recognised and communicated throughout the bank. Audit in banks is seen as a function independent of operating departments and in most cases the head of audit reports directly to the Chairman/Board. External statutory auditors also present their report on the functioning of the bank to its Board directly. The Board meets the senior management and internal audit regularly and establishes and approves policies and monitors progress towards corporate objectives. There is an independent audit committee of the board and the appointment and removal of auditors by the boards of banks have to be with the prior approval of Reserve Bank of India

The process of induction of directors needs to be streamlined. Further, considering the complex challenges that banks are required to meet in the future, there would be need for directors who are conversant with risk management issues. In order to enhance effectiveness of boards, there would also need to be a ceiling on the number of boards that a director can be on at the same time. To increase the effectiveness of boards, there is need for separate committees for risk management, compensation and for nominations to the board. While boards need to set standards of accountability for themselves, there is also a need for enhanced transparency and disclosures in respect of various aspects of boards’ constitution and functioning.

Sound corporate governance in Indian banks is hindered to some extent by the government/RBI ownership of banks. While, in the case of government ownership, the regulator may find it difficult to enforce urgent corrective action including removal of incompetent and, at times, corrupt management, in the case of RBI ownership, it leads to an overlap between its ownership and supervisory roles.

There are no laws as such which can be seen as supporting or facilitating corporate governance and absence of such legislation is felt. However, as regulators, as the Reserve Bank of India and SEBI are gradually introducing measures which lead to good corporate governance in banks and protection of depositors’ and others’ interests.