Friday, July 11, 2008

Corporate Governance in Banks

With the recent credit crisis weakening the financial position of several banks world-over, the question that is being repeatedly posed is whether the boards of directors of these banks could have foreseen the oncoming crisis or whether they should have taken steps to forestall a slide in their financial position. Fingers are being pointed not only at the executive management of these banks, but also at other independent board members.

In a recent column in the Economic Times, TT Ram Mohan laments the lack of adequate financial expertise among directors of banks that may have possibly led to their downfall. He notes:

“UBS, one of the world’s largest banks and among the biggest losers in the subprime crisis, is replacing four of its directors. The bank’s objective, according to its new chairman, is to strengthen the board with independent members with top-class financial or audit experience. The departing members include three outsiders with experience respectively in rail equipment, chemicals and information technology.


Lehman’s audit committee and risk committee has a theatre impresario as member. Citi has a former head of the CIA in the same roles — no doubt, the bank believes that experience in surveillance gained at the CIA has broader applications. Northern Rock’s chairman at the time of its collapse was a zoologist — presumably, this was meant to guard against wild bets on the part of management.”
He also questions the effectiveness of independent directors, even if they do possess the requisite expertise:

"One of the big improvements in corporate governance in recent years is said to be the institution of independent director. Boards are expected to have independent directors who will act as a check on management. But the idea that management, in its wisdom, would assemble the required expertise has taken some hard knocks. Many banks, it turns out, have big names aplenty. Banking expertise is sadly wanting.


To be sure, board expertise does not ensure that tough questions will be asked. Board members may have expertise but they may be unwilling to challenge and confront management. Anybody who has sat on boards knows that any attempt to probe or criticise can inject a jarring note into the proceedings. The superannuated souls who grace many a board prefer the quiet life."
Such concerns about the ineffectiveness of independent directors on such bank boards have also been raised elsewhere in the past. Two posts on the Finlay on Governance Blog are noteworthy. These are Did Bear Stearns Really Have a Board? and Cayne and Greenberg: Two Peas in a Very Dysfunctional Bear Stearns Boardroom Pod.

In an Indian context, the issue of expertise on bank boards has already been addressed by law. Section 10A of the Banking Regulation Act, 1949 requires that no less than 51% of the directors of every banking company should possess expertise in the area of accountancy, economics, banking, finance, law and such other areas. Indian banks’ boards are to be predominantly comprised of persons with financial or banking background. Further, when it comes to corporate governance, the banking sector is subject to greater regulation compared to other companies. For instance, the Reserve Bank of India (RBI) applies further checks and balance by ensuring a maximum term of 8 years for a bank director and also by possessing powers to reconstitute the board of directors and to approve the appointment and removal of directors in certain situations.

All these point towards the fact that corporate governance in banks (being in the financial sector) has very different implications compared to companies in other sectors. In India, banks are subject to the governance requirements prescribed by clause 49 of the listing agreement as well as those prescribed by the RBI. Other countries follow a slightly modified approach – e.g. Singapore has two sets of codes for corporate governance, one for banks and financial institutions and another for other companies. This approach takes into account the different governance requirements for different types of companies.

Lastly, as to independent directors, there conceptually seems to be a misplaced over-reliance by regulators, commentators and the media on this institution as if it is a panacea to all ills. That is perhaps not to be. Independent directors are only board members (and are not involved in the day-to-day management) who can provide strategic direction and oversight of the company’s affairs. There is still considerable debate over the effectiveness of independent directors in corporate governance, although conventional wisdom suggests that independence in the decision-making process on board will make it objective, impartial and diligent. What is required is to apply substance over form while examining the role of board members, whether independent or otherwise. A Note in the Harvard Law Review published a couple of years ago (119 Harv. L. Rev. 1553 (2006)) aptly sums up this point:

“Clearly, there is room for improvement. This Note rests on the premise that reliance on independence standards, if properly linked to the core functions implicated by those standards, can lead to practicable structural reforms that promote more effective corporate governance. The key is to reenvision independence as an institutional norm applicable to every director, rather than as an individual norm applicable only to formally independent directors. As such, the goal is to craft a functional conception of director independence that balances the normative goals of independence-based reforms against the behavioral constraints faced by modern boards. …


This Note’s conceit is that, by recasting independence as an institutional norm that prizes function over form, greater clarity can be brought to bear on the persistent problems of corporate governance. Assuming Adam Smith remains correct in his estimation of what managers are likely to do with “other people’s money”, this approach offers one method of enhancing the board’s ability to limit the damage caused by the separation of ownership from control. For when independence becomes the touchstone of the entire board—rather than the lonely province of the “independent” outsider – monitors, mediators and managers alike can shoulder its burdens and share in its promise. And whatever else regulators, courts, or commentators may say on the subject, it remains the independent board that stands the best chance, and bears the heaviest responsibility, of assuring investor confidence in the corporation.”

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