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Tuesday, July 30, 2019

Corporate governance in Indian banks: Embedded conflicts*

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. 

 II Corporate Governance in Banks

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).

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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