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BASEL COMMITTEE ON BANKING SUPERVISION

Corporate Governance in the Banking System


Third Pan-African Consultative Forum on Corporate Governance Dakar, Senegal 9 November 2005
Kirk Odegard Secretariat, Basel Committee on Banking Supervision

BASEL COMMITTEE ON BANKING SUPERVISION

Outline

Background
Sound corporate governance principles

The role of supervisors


Unique challenges Conclusions

BASEL COMMITTEE ON BANKING SUPERVISION

Background

BASEL COMMITTEE ON BANKING SUPERVISION

Background

Organisation for Economic Co-operation and Development (OECD) is international standard-setter for corporate governance
OECD issued corporate governance principles in 1999 Basel Committee issued guidance in 1999 applying OECD principles to banks Late 1990s/early 2000s: corporate scandals

OECD issued revised principles in 2004


Basel Committee currently reviewing bank guidance
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BASEL COMMITTEE ON BANKING SUPERVISION

Why guidance for banks?

Critical role in the economy


Need to safeguard depositors funds Importance of trust and confidence

High cost of bank failures


Sensitivity to liquidity crises Access to confidential customer information

Increasing complexity of bank activities

BASEL COMMITTEE ON BANKING SUPERVISION

Foundations of effective governance

Foundations of effective corporate governance are important but may be beyond supervisory control:
Macro-economic policies System of business laws Market integrity and transparency Accounting standards

Banking supervisors should be aware of impediments to sound corporate governance and take steps within their power to promote effective foundations

BASEL COMMITTEE ON BANKING SUPERVISION

Everyones responsibility

Board and senior management are primarily responsible for effective corporate governance
Others can help promote sound bank governance:
Shareholders Auditors Industry associations Governments Banking supervisors Stock exchanges and securities regulators Employees
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BASEL COMMITTEE ON BANKING SUPERVISION

Sound corporate governance principles

BASEL COMMITTEE ON BANKING SUPERVISION

Working Group on Corporate Governance


Established by Basel Committee to review guidance Incorporated elements of 2004 OECD principles Discussed lessons learned from corporate governance breakdowns Met with industry groups and rating agencies Consulted with non-BCBS supervisors Issued consultative paper in July 2005 Final paper expected late 2005/early 2006
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BASEL COMMITTEE ON BANKING SUPERVISION

July 2005 consultative paper


Apply to a wide range of banks and countries Applicable to diverse corporate and board structures Principles, not rules Not as prescriptive as some national legislation

Commensurate with bank size, complexity and risk profile


Not part of Basel II May be revised based on consultation
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BASEL COMMITTEE ON BANKING SUPERVISION

2004 vs. 1999 guidance


Introduction of know your structure guidance Expanded to consider group structures

Protection for whistleblowers


State-owned and other non-listed banks More in-depth discussion of:
Conflicts of interest Role of the board of directors Audit and other control functions Role of banking supervisors
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BASEL COMMITTEE ON BANKING SUPERVISION

Sound corporate governance principles


Strategic objectives and corporate values Clear lines of responsibility and accountability

Role of board of directors


Oversight by senior management Internal and external auditors and other control functions

Compensation policies and practices


Governing in a transparent manner Know your structure

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BASEL COMMITTEE ON BANKING SUPERVISION

Establishing strategic objectives and a set of corporate values that are communicated throughout the banking organisation.

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BASEL COMMITTEE ON BANKING SUPERVISION

Strategic objectives and corporate values

Should be established by the board of directors


Corporate culture should foster ethical behaviour Tone at the top is important Standards should address corruption, self-dealing and other unethical or illegal behaviour Whistleblowers: Employees should be encouraged to raise concerns about illegal or unethical practices to the board or an independent committee without fear of reprisal
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BASEL COMMITTEE ON BANKING SUPERVISION

Potential trouble situations

Lending to officers, employees or directors where allowed by national law


Consistent with market terms or terms offered to all employees Limited to certain types of loans Reports should be provided to the board

Subject to review by auditors and supervisors


Preferential treatment to related parties Conflicts of interest


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BASEL COMMITTEE ON BANKING SUPERVISION

Addressing conflicts of interest

Potential conflicts of interest arising from activities of the bank should be:
Identified
Prevented or appropriately managed
Information barriers between different units

Separate reporting lines and internal controls


Clear, fair, accurate information to customers

Appropriately disclosed

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BASEL COMMITTEE ON BANKING SUPERVISION

Setting and enforcing clear lines of responsibility and accountability throughout the organisation.

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BASEL COMMITTEE ON BANKING SUPERVISION

Board and senior management

Unclear lines of responsibility can make problems worse The board of directors should:
Define authorities and key responsibilities Oversee management actions

Senior management should:


Delegate responsibilities to staff and promote accountability Be responsible to the board for the performance of the bank
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BASEL COMMITTEE ON BANKING SUPERVISION

Accountability within banking groups

Parent board and senior management:


Set general strategies and policies for the group Determining governance structure for subsidiaries that best contributes to effective oversight Be aware of risks throughout the group Integrate and coordinate governance structures Responsible for governance of bank Soundness of bank, protection of depositors, compliance with laws and regulations Intra-group outsourcing (e.g. internal audit, risk management) do not eliminate bank board oversight Has ultimate responsibility for corrective action at the bank

Bank board and senior management:


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BASEL COMMITTEE ON BANKING SUPERVISION

Ensuring that board members are qualified for their positions, have a clear understanding of their role in corporate governance and are able to exercise sound independent judgment about the affairs of the bank.

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BASEL COMMITTEE ON BANKING SUPERVISION

The board should

Understand oversight role and duties to bank and shareholders


Avoid conflicts of interest Have sufficient time and energy to fulfill responsibilities Maintain collective expertise as bank grows

Implement targeted board training as necessary


Assess the effectiveness of its own governance practices Ensure bank has an appropriate plan for executive succession Question and receive information from senior management Provide sound and objective advice Do not participate in day-to-day management Exercise due diligence in hiring external auditors
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BASEL COMMITTEE ON BANKING SUPERVISION

Independent directors

Board should have adequate number of independent directors


Independence = ability to exercise objective judgment

Helpful if not members of bank management


Especially important in certain areas:
Ensuring integrity of reporting Review of related-party transactions Nomination of board members and key executives Board and key executive compensation
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BASEL COMMITTEE ON BANKING SUPERVISION

Ensuring that there is appropriate oversight by senior management.

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BASEL COMMITTEE ON BANKING SUPERVISION

Senior management responsibilities

Should have necessary skills to manage business and exercise appropriate control
Oversee line managers consistent with board policies

Critical role: Establishing system of internal controls


Situations to avoid: Inappropriate involvement in business line decisions Managing areas without skills or knowledge Inability to control star employees

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BASEL COMMITTEE ON BANKING SUPERVISION

Effectively utilising the work conducted by internal and external auditors, as well as other control functions, in recognition of their critical contribution to sound corporate governance.

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BASEL COMMITTEE ON BANKING SUPERVISION

Auditors and other control functions

Should be: Independent Competent Qualified Identify problems in risk management & internal control Ensure financial statements are accurate

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BASEL COMMITTEE ON BANKING SUPERVISION

Enhancing audit & control effectiveness


Recognise importance and promote throughout bank Enhance independence (e.g., limit non-audit services) Auditors have duties to bank and its stakeholders Consider rotation of audit firm or lead audit partner Utilise audit findings and require timely correction Report to the board or audit committee External auditors review internal controls Independent directors meet in the absence of bank management with external auditor and heads of internal audit, compliance, legal functions
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BASEL COMMITTEE ON BANKING SUPERVISION

Ensuring that compensation policies and practices are consistent with the banks ethical values, objectives, strategy and control environment.

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BASEL COMMITTEE ON BANKING SUPERVISION

Board and key executive compensation

Compensation should be consistent with: Long-term business objectives and strategy Corporate culture Control environment Should not overly depend on short-term performance Board (or independent committee) should approve compensation Policies re: trading bank stock and granting/re-pricing stock options
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BASEL COMMITTEE ON BANKING SUPERVISION

Conducting corporate governance in a transparent manner.

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BASEL COMMITTEE ON BANKING SUPERVISION

Transparent governance

Necessary for shareholders, other stakeholders and market participants to monitor and hold accountable the board and senior management Need information on corporate structure and objectives Complex cross-shareholdings can impede transparency At a minimum, all banks should make disclosures to supervisors

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BASEL COMMITTEE ON BANKING SUPERVISION

What should be disclosed?


Disclosure on public website or in annual report:

Board and senior management structure

Organisational structure (including ownership)


Incentive structure of the bank Code of business conduct and/or ethics

Related-party transactions
Full annual financial statement with supporting notes and schedules

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BASEL COMMITTEE ON BANKING SUPERVISION

Maintaining an understanding of the banks operational structure, including operating in jurisdictions, or through structures, that impede transparency (i.e. know your structure).

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BASEL COMMITTEE ON BANKING SUPERVISION

Operational structure

Some bank operations may lack or impair transparency Particular jurisdictions (e.g. some offshore centres)

Complex structures (e.g. special purpose vehicles or corporate trusts)

Banks may provide services or establish opaque structures for clients Often legitimate and appropriate business purposes

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BASEL COMMITTEE ON BANKING SUPERVISION

Supervisory concerns

The use or sale of opaque structures/products may:


Pose potentially significant financial, legal and reputational risks

Impede board and senior management oversight


Hinder effective banking supervision

Risks should be appropriately assessed and managed

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BASEL COMMITTEE ON BANKING SUPERVISION

Risk management expectations

Clear policies and procedures should be in place Approval for use and sale

Identify and manage all material risks


Need for such activities should be regularly assessed Corporate governance expectations should be established for all relevant entities Activities should be subject to enhanced audit procedures and internal control reviews Assess compliance with applicable laws, regulations and internal policies and procedures
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BASEL COMMITTEE ON BANKING SUPERVISION

The role of supervisors

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BASEL COMMITTEE ON BANKING SUPERVISION

Supervisory role

Poor corporate governance practices can be a cause or a symptom of larger problems


Banking supervisors should:
Promote strong corporate governance
Determine whether the bank has sound corporate governance policies and practices Hold the board of directors and senior management accountable for governance and internal control weaknesses Be attentive to warning signs of deterioration in management Consider issuing supervisory guidance for governance
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BASEL COMMITTEE ON BANKING SUPERVISION

Supervisory questions

Does the board exercise effective oversight?


Are controls to detect and mitigate conflicts of interest adequate? Are internal controls properly implemented (as opposed to being written down but not operational)?

Do internal and external audit functions conduct independent and effective reviews?
Are major shareholders, directors and managers fit and proper? Will an individuals skills and experience contribute to bank safety and soundness? Does criminal or regulatory record make a person unfit?

Is a group structure managed in such a way as to negatively impact management of the bank?
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BASEL COMMITTEE ON BANKING SUPERVISION

Unique challenges

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BASEL COMMITTEE ON BANKING SUPERVISION

Controlling shareholders

For example, family-owned or other non-listed banks


Controlling shareholders can be a valuable resource Unique governance challenge because of influence

There should be sufficient checks and balances on inappropriate activities or influences


The board and its directors have responsibility to the company and all of its shareholders Supervisors should be able to assess fitness & propriety of bank owners
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BASEL COMMITTEE ON BANKING SUPERVISION

State-owned banks

OECD has issued guidance for state-owned enterprises


General principles should be applied to state-owned banks Ownership and supervision functions should be fully separated Government should not be involved in day-to-day management Board independence from political influence should be respected Objectives of state ownership and states ownership policy should be disclosed
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BASEL COMMITTEE ON BANKING SUPERVISION

Two-tier boards

Some countries adopt a two-tier board of directors (e.g. management board and supervisory board)
Basel Committee recognises that both one-tier and two-tier boards may be appropriate Two-tier boards may be structured differently across jurisdictions, so no specific guidance Whichever structure is used, principles of sound corporate governance should be in place

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BASEL COMMITTEE ON BANKING SUPERVISION

Conclusions

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BASEL COMMITTEE ON BANKING SUPERVISION

Wrapping up

Banks have a unique role in the economy, so targeted corporate governance guidance is appropriate

Key elements:
Board of directors = oversight Senior management = internal controls Supervisors = promote and assess sound governance

Actual practice is just as important as written policies and procedures

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BASEL COMMITTEE ON BANKING SUPERVISION

Questions or Comments?
Kirk Odegard Member of Secretariat Basel Committee on Banking Supervision Bank for International Settlements kirk.odegard@bis.org

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