Today virtually every industrialized
nation is seriously engaged in defining the kind of “corporate governance” that
should be put in place to manage the economic activities. Corporate governance
is an umbrella term that encompasses the economic, legal and institutional
effort that allows companies to diversify, grow, restructure, and exit and do
everything necessary to maximize shareholder value. According to Shleifer and
Vishny (1997) corporate governance deals with the ways that suppliers of
finance to corporations assure themselves of getting a return on their
investment. “Doing everything better” is how corporate governance is defined today.
As the Nobel laureate Milton Friedman observed today corporate governance has
become much more than the conduct of business in accordance with shareholders’
desires.
It became synonymous with a system of
making a corporate both a powerful economic entity and an important social
institution that uses its economic power to add value to society generally and
to people’s lives individually. This new moral compact between the corporate,
the individual and the society is essentially aimed to transform corporates as
value creating institutions.
Against this backdrop, it is evident that
very little attention is being paid towards corporate governance in banks
though, ironically, banks arrogate to themselves the role of ensuring right
kind of “corporate governance” in the businesses to whom they lent money
(Jonathan R. Macey and Maureen O’Hara, 2003). In the light of these realities,
this paper makes an attempt to trace; I - Corporate governance: theory and
practice; II – corporate governance in banks: specific problems; III –
corporate governance & embedded conflicts in India and IV –measurers to
resolve conflicts and better the corporate governance.
I - Corporate governance:
Theory and Practice
Corporate governance is essentially
concerned with the matters arising out of separation of ownership and control
and this can be traced back to the works of Adam Smith (1776) and Berle and
Means (1932). Narrowly it is considered as a mechanism through which
shareholders are assured that managers will act in their interests (Berle and
Means, 1932). However it is argued that
managers do not always act in the best interests of shareholder (Henderson,
1986). The separation of ownership and control has given rise to an agency problem
whereby the management operates the firm in its own interests but not
necessarily those of shareholders (Jensen and Meckling, 1976: Fama and Jensen,
1983).
Several factors are found to be effective
in reducing these principal - agency costs. The “market for managers” is one
such measure which is found to penalize management teams that tried to advance
their own interests at shareholder expense (Fama, 1980). Shareholders can also
manage this conflict by creating incentive compatible compensation
arrangements.
In this intellectual debate a question
has emerged: whether corporate governance should focus exclusively on
protecting the interests of equity claimants in the corporation or whether
corporate governance should instead expand its focus to deal with the problems
of other groups called non-shareholder constituencies.
The existing difference between Anglo-American
model of corporate governance that usually focuses on maximization of
shareholder’s wealth and the Franco-German model which looks at corporates as
“industrial partnerships” and thus extends its focus beyond the immediate
requirements of shareholders appears to have intensified the search for a
‘best-fit’ governance.
One school of thought, looking at
corporates as “a complex web of contractual relationships among the various claimants
to the cash flows of the enterprise” argues that the fiduciary duties of
managers and directors of companies should not confine to maximization of the
firm value for shareholders alone but also extend to ensure safety and
soundness of the enterprises.
Commercial banks pose unique corporate
governance problems for the number of parties with a stake in an institution
activity complicates the governance requirements. Besides investors, there are
the depositors and regulators who have a direct interest in bank performance.
The regulators are concerned about the effect of corporate governance on the
performance of banks since the health of the overall economy rests on their
performance.
The gravity of the challenges can well be
understood from the bank’s balance sheets, which reflect high leverage coupled
with embedded mismatch between assets and liabilities and the very special role
they play in maintaining the stability of the financial system.
Banks liabilities are mostly in the form
of deposits while their assets are mostly loans that have a longer maturity. By
holding illiquid assets and issuing liquid liabilities banks create liquidity
for the economy (Diamond & Dybig, 1986). Banks are thus special in their
liquidity production function.
Banks are quiet opaque. It is very
difficult for outsiders to monitor and evaluate banks while its opacity enhances
the ability of managers to shift their activities quickly and massively for the
own gain.
Government regulations frequently cripple
natural corporate governance mechanisms. For instance, deposit insurance
reduces monitoring by insured depositors, reduces the desirability of banks to
raise capital from large, uninsured creditors, and increases incentives for shifting
bank assets to more risky investments. Regulatory restrictions on entry,
takeovers, etc., reduce competition, which in turn reduce market pressures on
mangers to maximize profits.
Government interventions in terms of
restriction on ownership, pricing of services etc., also limit competitive
forces in banking. Banks in emerging markets are subjected to a variety of
restrictions: Minimum branching requirements (often in rural areas), directed
credit guidelines, portfolio restriction or liquidity requirements, limits on
interest rates and fees etc. In banking the most insidious form of intervention
that lessens the potential discipline of market forces is perhaps the
resistance offered to either allowing a bank to fail or to close the bank
because of the government’s concern for depositors, fear of contagion, etc.
In many developing economies, government
ownership of banks is a common feature (La Porta et al, 2002). With a
government-owned bank the severity of the conflict between depositors and managers
heavily rests on the credibility of the government (T.G. Arun and J.D. Turner).
Another severe problem that government owned banks face is the conflict between
themselves and the bureaucrats who control the bank. Bureaucrats may seek to
advance their political careers by catering to special interest groups such as
trade unions (Shleifer and Vishny, 1997, p.768).
III. Corporate governance & embedded conflicts
About four-fifths of banking business in
India is under the control of public sector banks. This phenomenon complicates
corporate governance in PSBs since the effective management vests with the
government while the top managements and boards of banks operate merely as
functionaries.
The government as owner of majority of
banks in India often found simultaneously performing multiple functions such as
the “owner”, “manager”, “quasi regulator” and sometimes as the “super
regulator”. In view of this even if tomorrow government dilutes its holdings
below 51%, good governance practices are likely to remain at superficial level
unless it redefines its very role de novo.
In order to give representation to
various sections of the society in the boards of PSBs, government is appointing
people from all walks of life, to the boards. At times such government
nomination assumes a degree of political patronage too. The rights of private
shareholders are also abridged very considerably: they cannot influence the
composition of the board or the compensation package or even the selection of
statutory auditors. There is no equality among the various board member of the
PSBs as certain committees of the board cannot function without the
government/RBI directors’ participation. (MG Bhide, A Prasad and Saibal Ghosh,
2001) Further the presence of the Reserve Bank of India nominee on the board of
directors engenders conflict of interests with its regulatory function.
The Indian banking system is no exception
to the menace of non-performing loans that are incidentally policy induced (Joshi, 1998). The threat posed by the unabatedly
rising NPAs, partly owing to the directed lending, etc has already created
liquidity problem in the Indian banking sector. Although Narasimham Committee-II recommended for its
abolishment, it is more unlikely at least, in the near future as
directed-lending in India relates to agriculture, SSI and priority groups ( Montek S Ahluwalia,1999).
Another stumbling block that Indian banks
face is the inability to shuffle their loan portfolio based on the changing
market scenario. Even during the days of downturn, banks are not in a position
to bring down their exposure to industries that are passing through recession.
For instance, during the last four years, steel, cement and infrastructure segments
of the Indian economy are not doing well and yet there is no perceptible
change/reduction in exposure levels of banking sector to these segments. As information in financial markets is
inherently asymmetric (Stiglitz and Weiss,1981)
banks are expected to act as agents gathering information and allocating credit
to the highest risk- adjusted-return (Bernanke, 1983) and failure in this regard
tantamount to poor corporate governance.
Similarly, the success of ALM hinges
critically on the availability of trained and skilled manpower besides the availability
of reliable data from branches about the assets and liabilities and the daily
movement thereunder across the system. Here, the board of directors has a
greater responsibility in laying down risk parameters and management systems
for the bank as a whole. But, Indian banks’ boards are today mostly filled with
people who are not that conversant with risk management techniques.
Corporate debt restructuring is one of
the suggested methods to reduce NPAs: it essentially aims at rescheduling the
debt portfolio of the borrowers and helps revive their projects. Such timely
restructuring of debt calls for a high degree of imagination and
innovativeness, which is sadly missing among the major Indian banks. One of the
oft-quoted reasons for such “learned-helplessness” is the fear of “vigilance”.However,
with the recently introduced bankruptcy law, this position is likely to be
improved. Nevertheless, unless entrepreneurs become honest and fair in their
managing businesses, no improvement in the problem of twin-balance sheets can
be wished away.
IV. A resolution mechanism
Board members must be well versed in the
complexities of banking and its management in the dynamic globalized economy.
It should be capable to bringing in better information, offering new
perspectives to manage the risk-profile of a bank. They should focus on
debating new strategies and policies rather than reviewing past performances.
All this calls for appointment of such professionals to the board who have
requisite qualifications and technical expertise on the lines suggested by the
BIS.
The independent/non-executive directors
should have the necessary wherewithal to raise critical questions relating to
business strategy, management of bank and investor relations at the board meetings.
They must provide effective checks and balances to protect stakeholders
interests. In short the board members should have sufficient-enough expertise
to foster effective decisions and reverse failed policies. Their aim should be
to decrease the possibility of mistakes and to increase the speed with which
they are corrected. (John Pound, 1995)
In order to attract quality professional
to the boards, the level of remuneration payable to the directors should be
increased proportionate to the quality of inputs expected from them. Besides
they must also be provided with wholesome, complete and adequate information to
enable them to raise meaningful critical questions and take meaningful
decisions.
It is desirable to separate the office of
chairman and managing director so that the chairman can focus more on strategy
and vision while MD can focus on operational efficiencies. Secondly they must
have sufficiently long tenure so that they could leave a mark of their
leadership and business acumen on the bank’s performance.
The threat of ‘vigilance’ needs to be
re-looked into, so that the executives are encouraged to take radical business
decisions with agility.
The viscous problem of NPAs should be
addressed through institutionalizing a sophisticated system of credit
assessment and an integrated risk management mechanism, backed by a prompt and
efficient legal framework. This calls for organizational restructuring,
improvement in managerial efficiency, skill up gradation for proper assessment
of creditworthiness and an attitudinal change towards legal action (Jalan 2001)
The banking system must be supported with
a legal system which facilitates the enforcement of financial contracts
promptly (M. G. Bhide, A. Prasad and Saibal Ghosh, 2001).
Conclusion
In Layman’s words, Corporate Governance
is understood as “the distributions of rights and responsibilities among
different participants in the corporation, such as, the board managers,
shareholders and other stakeholders, and spells out rules and procedures for
making decisions on corporate affairs”
In the wake of changes brought about by
globalization, deregulation and technological advances banks are facing
increased risks. Moreover unlike in other firms, banks conduct their business
with funds belonging to the depositors. Linked to this is the fact that the
failure of a bank not only effects its own stakeholders but may have a systemic
impact on the very stability of banking architecture. Hence Corporate
Governance is particularly important for banks.
The boards must therefore play a
leadership role in approving the strategy and business plans of the banks,
monitoring the performance of the managers and ensuring that the internal
control and risk managers systems are effective. It should also ensure that the
banks conduct its business with integrity and in accordance with high ethical
standards.
*Written
in the early 2000s, yet has relevancy
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