Corporate Governance and the Financial Crisis

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1 February 2010 L esso ns Lea r n e d Ser i e s Improving Banks Corporate Governance Practices In Southeast Europe Forum, EBRD, and IFC Join Efforts to Help Financial Institutions, Regulators Adopt Best Practices for Conducting Business Countries worldwide were hit, some harder than others, by the combination of risky lending and highly leveraged investment strategies by Western financial institutions that quickly engulfed the globe in an economic and financial crisis between 2007 and The crisis exposed the interdependencies, and how we underestimate the extensive global links between economies on opposite sides of the globe, observed Teodor Volcov, a board member with Volksbank in the Ukraine. For financial institutions, we must be more guarded in our use of economic models, for example, to guide our decisions on the level of risks we will assume and the types of investments we will make. Prior to the financial crisis, Southeast Europe (SEE) had seen strong expansion with growth in the region s gross domestic product (GDP) reaching 6.3 percent in 2007, accompanied by low unemployment. Political and economic risk had subsided by then, which the credit rating agencies recognized by raising their ratings, triggering a rise in foreign direct investment (FDI) inflows. All that changed as the financial crisis rapidly took hold worldwide in By the end of 2008, real GDP growth in emerging countries in Europe, for example, slowed to 4.2 percent; in 2009, it fell 6.6 percent. The International Monetary Fund has forecast a weak recovery for 2010, with GDP rising 1.7 percent. 1 This trend reflects the region s increasingly developed trade and financial links with the highly developed economies. Now, the focus shifts to promoting a sustainable recovery, with banks and investment firms playing a central role. Discussions on innovative solutions for weathering the crisis s aftermath and policy responses geared towards a recovery are at the The Global Corporate Governance Forum is a multidonor trust fund facility located in the IFC s Business Advisory Services. The Forum was co-founded by the World Bank and the Organisation for Economic Co-operation and Development (OECD) in Through its activities, the Forum aims to promote the private sector as an engine of growth, reduce the vulnerability of developing and transition economies to financial crisis, and provide incentives for corporations to invest and perform efficiently in a socially responsible manner. The Forum sponsors regional and local initiatives that address the corporate governance weaknesses of middle- and low-income countries in the context of broader national or regional economic reform programs. Donors to the Forum include the IFC and the Governments of Austria, France, Luxembourg, the Netherlands, Norway, and Switzerland.

2 top of national agendas in the SEE region. These efforts have put a new spotlight on how banks can improve their governance. In their key roles in the credit and investment process, banks are especially well-placed to benefit from and lead efforts to improve corporate governance in SEE. Shortcomings in bank corporate governance can destabilize the financial system and create systemic risks to the economy. Non-transparent and ambiguous lending practices put many customers at the risk of overindebtedness, said Kemal KozariÄ, governor of the Central Bank of Bosnia and Herzegovina. The global financial crisis has proven that the principle of responsible finance has not been sufficiently developed with banks and with clients. It has now become evident that the liquidity risk of banks in Bosnia and Herzegovina, for example, is rather low, but that the main problem is the quality of loans. Disseminating responsible principles of finance is considered to be one of the primary responses to the financial crisis. To help improve the transparency and accountability of the financial sector in SEE, the Global Corporate Governance Forum, the IFC, and the European Bank for Reconstruction and Development (EBRD), jointly organized a two-day meeting in Belgrade in December severe weaknesses in what were broadly considered to be sophisticated institutions. Many corporate governance tools proved to be ineffective when faced with unexpected pressures and strong conflicts of interests. Given the prevailing role of banking institutions as a source of finance in SEE, it is of the utmost importance to improve bank s governance, said Gian Piero Cigna, senior counsel with the EBRD. Moreover, banks are in a unique position to influence the corporate governance of their corporate borrowers. They can become role models for other companies in implementing high standards and best practices. Private Sector Advisory Group (PSAG) Chairman Peter Dey chaired the high level policy meeting, The workshop helped me to better understand how my financial institution can take steps to better insulate itself against disruptions in regional and global capital markets. The exchange of ideas brought forward other institutions post-crisis responses and their rationales. Kalinka Dimitrova Head of Division, Bulgarian National Bank The Forum and IFC Advisory Services thank EBRD and the governments of Luxembourg, Austria, and the Netherlands for their support. The sessions supported the region s countries in developing action plans and specific policy recommendation. More than 70 banking regulators and practitioners from Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Macedonia, Montenegro, Romania, and Serbia attended. This program, too, helped inform the development of a Forum training module tailored to bank directors. Supplementing the Board Leadership Training Resources, the new module will draw on the latest thinking about bank risk management after the financial crisis. Along with macroeconomic drivers, corporate governance failures have played a very relevant role in this crisis, said Hans Christiansen, a senior economist within OECD Corporate Affairs and a speaker at the Belgrade meeting. There were 2 1 International Monetary Fund, Regional Economic Outlook: Europe: Security Recovery. Washington, DC: IMF, October Available at:

3 while eight other PSAG members participated, leading discussions and breakout groups that led to action plans in the eight countries represented. On the program s first day, central bank governors from Bosnia and Herzegovina, Montenegro, and Serbia and the Vice-Governor from Macedonia participated in a panel discussion on banks supervision and enforcement. Standards and best practices of corporate governance in banks should be continuously monitored and reviewed, said Radomir Bozic, vice governor for the Central Bank of Bosnia and Herzegovina. They must be tailored to the specific environment in which banks operate and their customers needs. Other issues discussed during the first day included the state of SEE banks corporate governance practices and behavior, the lessons learned from the financial crisis, European Union trends including corporate governance best practices, effective approaches to supervision and enforcement of financial regulations, reform priorities, and recommendations for strengthening corporate governance of SEE banks. During the discussions, two unique circumstances of the region s banks became more clear. Many are closely held by a dominant shareholder or group of shareholders. Most of the others are subsidiaries of Western banks. These structures have ramifications for corporate governance, for example, in terms of the communications between the parent and subsidiary entities, said Jon Lukomnik, a Forum consultant and both founder and managing partner of Sinclair Capital LLC. The financial crisis underscored the need for parents to keep the subsidiaries better informed of their operations and risks. One participant observed: It used to be that the parents were concerned about the health/prudence of the subsidiaries. During the crisis, that was reversed and the subsidiaries often were concerned and felt WHAT WENT WRONG? Ian Radcliffe, director, training and consultancy, for the World Savings Banks Institute - European Savings Banks Group, pointed to the following as the root causes of the financial crisis: Financial innovation went astray Flawed incentive structures Poor risk management Supervisory deficiencies International governance deficiencies Source: Ian Radcliffe, EU Trends and Best Practice. Presentation before the SEE Corporate Governance of Banks High Level Policy Meeting. December 9, Available at: This meeting is an important step towards establishing improved standards of business conduct and thereby promoting recovery in the region. Dragan Dzinic Legal Advisor, Nova Bank, Bosnia and Herzegovina It was very useful to learn about different approaches to common problems, see other points of view, and meet people confronting similar problems. Nevena Nastic Associate Specialist Internal Control, Belgrade Stock Exchange uninformed about what was happening at the parent level. International trends, such as Basel II, which sets minimum capital standards for banks, are putting more emphasis on the supervisory role of boards in understanding and monitoring the risks taken by the bank in its operations, said Philip Armstrong, the Forum s head. That underscores the need for building board capacity, which the Forum is addressing through a training program it specifically designed to support the financial recovery. Transparency and disclosure, including financial statements, mandatory external audit, and various financial and non-financial information in accordance with the standards and best practices of corporate governance, are necessary for the depositors and savers, and building and maintaining confidence in the bank, said one participant. During the second day, banking sector representations formed teams for each of the eight countries represented at the conference. Coached by an international expert, each country team discussed the characteristics of the national banking sector and then developed for their respective Corporate Governance Lessons for Banks from the Financial Crisis Build a banking sector sufficiently robust to withstand systemic risks Review periodically the bank s strategic objectives for example, credit growth, foreign exchange lending to ensure that the focus is on sustainable growth Strengthen risk management policies and procedures, including assessment, currency/maturity mismatches, related-party exposure, and problem loans Define a strong role for banking supervisors that encompasses cross-border supervision and the promotion of transparency through information disclosure requirements Source: Kiyoshi Nishimura, EBRD, Corporate Governance of Banks in Southeast Europe. December Available at: 3

4 countries a ten-point action plan to strengthen banks corporate governance over one year. The participants generally agreed on the importance of robust interactions between directors and management, as one put it. Particularly key here is the CEO s attitude toward the board, since that has a tremendous impact on the board s relations among its directors and with management. Getting the right set of experiences in the boardroom was a recurring theme of the discussions. ACTION PLAN TO IMPROVE CORPORATE GOVERNANCE The country developments action plans specifically tailored to their countries environment and needs, based partly on the impact that the financial crisis had on their financial institutions and capital markets. Conclusions from the Belgrade meeting will help inform policy recommendations on the governance of SEE banks. These suggestions will be further discussed by the regional working group and finalized at the second meeting in late 2010 at EBRD headquarters in London. Common elements in the action plans developed at the Belgrade meeting included considering requirements in the following areas: Boards, Board Members and Specialized Committees Determine the minimum number of independent directors on banks supervisory boards Delineate the board audit committee s composition, including the participation of nonexecutive and independent directors Banks Strategic Objectives, Corporate Values, and Standards for Corporate Behavior Situation Assess regularly banks actual operative and financial results in the context of strategic and business decisions Promote and supervise the implementation of high standards of corporate governance Establish procedures for preventing conflicts of interest, including related-parties operations and beneficial ownership, which can differ from legal or registered ownership, and require disclosures Mandate regular risk assessments, especially for new products, to ensure that banks understand their exposure to operational and other risks Clear Lines of Responsibilities and Accountability Clarify the lines of responsibilities and duties of boards and senior management Establish the appointment process for directors including independent and nonexecutive ones to the Supervisory Board, the Audit Committee, and other bodies Oversight by Senior Management and Internal Control Functions Determine regulations to require banks to have every two years an independent, external review of their risk management and internal control systems Provide to regulatory agencies external audit reports on banks loan exposures and their provisions for handling non-performing loans Establish whistle-blowing procedures Internal and External Audit Strengthen the independence of internal audit practices Consider prescribing powers to banking regulators that set out criteria for determining and documenting external auditors independence in harmony with international regulations and practices Communications Determine publication process for the remuneration policy for senior management to enable all stakeholders to assess whether the compensation is aligned with the performance of the bank and its management Evaluate communications between parents and subsidiary banks and agree on reforms to ensure effective dialogue and informationsharing. Transparency and Disclosure of Corporate Governance Information Prescribe disclosures that enhance the accountability of banks to savers, depositors, other clients, and stakeholders Monitoring Bank Clients Corporate Governance Practices Establish procedures to monitor the corporate governance of banks clients 4

5 Participants acknowledged the value of appointing functional and sector experts to the board, but emphasized the merits of diversity and broad, seniorlevel leadership expertise. They described factors that complicate changes to board composition, such as loss of institutional knowledge, and the elements required to execute such changes successfully. Participants said they believe that directors should demand higher-quality information from management and should be more proactive in seeking out independent advice. Insights from regulators, shareholders, and others can be highly beneficial. Further, there should be a clear line established between management and board oversight; directors should not be drawn into day-today decisions about a banks operations. So, what s coming? Professor David Beatty from Rotman School of Business, University of Toronto, chairman of the Risk Review Committee and Executive & Governance Committees of Bank of Montreal, and Forum s PSAG member provided insights on the board s role in corporate governance and what s coming next: Capital Definitions will be harmonised: Consistency, transparency and comparability internationally Internationally harmonized leverage ratio (asset-to-capital) Regulatory Capital Requirements will increase: Capital buffers above Tier 1 capital ratios* Solo capital available domestic capital Stiffer definitions of Tier 1 capital Contingent capital Global Best Practices will be promulgated: Governance processes and structures Liquidity risk oversight Counterparty risk practices Stress testing scenarios * The Tier 1 capital ratio is the ratio of a bank s core equity capital to its total assets. It is a metric of a bank s ability to sustain future losses. The discussions in Belgrade in December 2009 will help inform the Forum s Financial Markets Recovery Project. This program will develop and integrate supplemental materials specifically relevant to financial institutions. These materials will draw on the latest thinking about bank risk management. 5

6 Focus on Board Quality Christian Strenger, the PSAG deputy chairman, emphasized the need for high-quality boards to guide financial institutions and outlined his recommendations based on his extensive experience in advising boards. The lack of quality in boards was a major reason for the financial crisis, in his view. The growing liability of boards and the increasingly complex subjects that directors must consider necessitate training to ensure that directors are adept and well-informed to guide the board s deliberations. More intense competition among financial institutions requires adherence to corporate governance best practices to succeed. Key areas for improvement typically include: Expertise of non-executive board members Supervision and risk oversight procedures and policies Management of conflicts of interest Transparency Ethical standards Alternative dispute resolution mechanisms Success Factors for Building Highly Effective Boards The consultancy Tapestry Networks examined the critical success factors for building highly effective boards. They found the following factors are key: Forging a relationship with management in which constructive challenge is both expected and respected. Developing robust interactions between directors and management Building a high-impact, effective board Getting the right set of experiences in the boardroom Ensuring directors have access to critical information from inside and outside the firm Respecting the line between management and board oversight Source: Tapestry Networks, Building a High-Impact, Effective Board. Suggest Reading Enhancing Corporate Governance for Banking Organizations, Basel Committee, February EBRD-OECD Policy Brief on Corporate Governance of Banks in Eurasia. law. Policy Brief on Improving Corporate Governance of Banks in the Middle East and North Africa, Global Corporate Governance Forum, Hawkamah, OECD, Union of Arab Banks. November Report on Bank Boards and the Financial Crisis A Corporate Governance Study of the 25 Largest European Banks, Nestor Advisors. May The High-Level Group on Financial Supervision in the EU-Report (De Larosiére-Report). February Next issue: An independent evaluator examines how the Forum utilizes partnerships, leverages resources, and integrates local perspectives into its corporate governance initiatives. A Review of Corporate Governance in UK Banks and other Financial Industry Entities: Final Recommendations (Walker Review). November 26, walker_review_ pdf. The Turner Review A Regulatory Response to the Global Banking Crisis. March 18, The Global Financial Crisis: Preliminary Evidence in South East Europe and Responses from Governments, OECD. dataoecd/30/39/ pdf. The Corporate Governance Lessons from the Financial Crisis, Grant Kirkpatrick. OECD. February dataoecd/32/1/ pdf. LEARN MORE Global Corporate Governance Forum 2121 Pennsylvania Ave., NW Washington, DC USA Tel: +1 (202) Fax: +1 (202) cgsecretariat@ifc.org