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STRUCTURE AND MECHANISM OF CORPORATE GOVERNANCE IN THE

INDIAN BANKING SECTOR

The banking sector serves as the main source of resource mobilization in

developing economies. Due to underdeveloped money markets and capital markets,

limited availability of financial instruments and a lack of confidence in the financial

system, banks become the dominant financial i~&rmedia . in the system. Given the

bank's intermediary role in providing stability to the financial system, many

emerging economies have implemented policies to develop and restmcture the

banking sector. These policies have included denationalization and privatization of

banks, interest rate deregulation and a more efficient role of the Reserve Bank and

the development of a system of self-disciplined bank management. Banks in India

have followed and implemented similar reform policies in the 1990s to improve the

banking sector to make them more efficient and profitable. Part of this was achieved

by regulatory restructuring in line with the recommendations of Basel Accord.

Another important feature of these policies was to design guidelines for 'Best

Practices7 known as, 'Corporate Governance of Banks'. (Ahrned M. Khalid,

Muhammad N. Hanif.2005)

Corporate governance is particularly important for banks, given the bank's

important role in the financial sector. The rapid changes brought about by

globalization, deregulation and technological advances are increasing risks in the

banking systems. Moreover, unlike other companies, most of the funds used by

banks to conduct their business belong to their creditors, in particular their

depositors. Linked to this is the fact that the failure of a bank affects not only its own

stakeholders, but may have a systemic impact on the stability of other banks.

(Donald Brash 2001) Theoretically, information asymmetry gives rise to agency

problems and conflicts of interest between owners and managers. Good corporate

governance is designed to address this problem. Further, government regulations and

frequent interventions reduce the 'incentive for effective monitoring and at the same

time make supervision less effective. In this context, the corporate governance of

banks becomes a more important challenge as compared to governance of other

firms. (Ahrned M. Khalid, Muhammad N. Hanif.2004)

Internationally, the issue of corporate governance for banks has been

recognized as one of the most important issues of the corporate sector. The OECD

has produced a set of corporate governance principles that have become the core

template for assessing a country's corporate governance arrangements. Similarly, the

Basel Committee on Banking ~u~ervision made recommendations for the

corporate governance of banks. Following the recommendations of the Basel

Committee, OECD and the EMF, many developed countries have designed policies

to implement best practice bank management. Developing countries, especially

emerging economies in the South Asian region, followed the same recommendations

and introduced certain guidelines for corporate governance. In India (as well as other

South Asian countries), the banking sector restructuring took place only in the early

1990s and some steps towards good governance were initiated in late 1990s and

early 2000. As such, not enough time has passed to conduct a meaningful

assessment of the impact of these policies on bank efficiency.

Pre-reform status

The regulatory framework for the banking industry under the Banking

Regulation Act was circumscribed by the special provisions of the Bank

Nationalisation Act both of which had elements of corporate governance

incorporated with regard to composition of Board of Directors in terms of

representation of directors, etc. While technically there was competition between

banks and nonbanks and among banks, substantively, competition was conditioned

by policy as well as regulatory environment, common ownership by the Govemment

and agreement between the Government of India as an owner and the workers

represented by the Unions. Subsequent efforts during the reform period in terms of

hesitancy in permitting industrial houses as well as foreign owned banks should be

viewed in this historical context.

As regards the policy environment, it must be recognised that almost the

whole of financial intermediation'was on account of public sector, with PSBs being

the most important source of mobilisation of financial savings. Resources for DFIs

were also made available either by banks or mostly created money and

governmental support. The major thrust was on expansion of banks, b ranch ,

provision of banking services and mobilisation of deposits. The interest rate regime

was administered with interest rates fixed both on deposits and lending. At the same

time, there was large pre-emption of banks. Resources under the cash reserve ratio

or in the form of statutory liquidity ratio. The delivery of credit was also, by and

large directed through an allocate mechk~sm or as an adjunct to the licensing

regime. In the process, the private sector banks tended to be confined to the local

areas and were unable to expand in such an environment. Banks, mainly public

sector banks became the most dominant vehicle of the financial intermediation in the

country. To a large extent, entry was restricted and exit was impossible and there

was little or no s&pe for fimctions of risk assessment and pricing of risks. The

Government thus combined in itself the role of owner, regulator and sovereign.

The legal as well as policy h e w d r k emphasised co-ordination in the

interest of national development as per Plan priorities with the result, the issue of

corporate governance became subsumed in the overall development framework. To

the extent each bank, even after nationalization, maintained its distinct identity,

governance structure as incorporated in the concerned legislations provided for a

formal structure of relationship between the RBI, Government, Board of Directors

and management. The role of the RBI as a regulator became essentially one of being

an extended arm of the Government so far as highest priority was accorded to

ensuring coordinated actions in regard to activities particularly of PSBs. The SBI,

which was owned by the RBI, was in substance no different fiom the other banks

owned by the Government in terms of Board composition, appointment procedures

of the executives and non-executive members of the Board of Directors. Both

Government and RBI were represented on the Board of Directors of the PSBs. There

has been significant cross representation in terms of owner or lender and in other

relationships between banks and all other major financial entities. In other words,

cross holdings and inter-relationships were more a rule than an exception in the

financial sector, since the basic objective was coordination for ensuring planned

development, with the result, the concepts of conflicts of interests among players,

checks and balances etc., were subordinated to the social goals of the joint family

headed by the Government. (Y V Reddy 200 1).

Obstacles on the Path of Good Governance in Banking Sector

There are several reasons for the absence of a sufficient corporate

governance mechanism in the Indian banking sector.

MultipUcci@ of regulations: Banks are governed by multiple enactments. For

instance, private banks are governed both by the Companies Act, 1956 and the

Banking Companies Regulation Act. The nationalized banks are governed both by

the Banking Companies Regulation Act and &e Bank Nationalization Act, 1969

(amended in 1982). The State Bank of India and its associates are governed by the

State Bank of India Act, 1955 (amended in 1997), The, regional Rural Banks are

regulated by RRB Act, 1975, the Co-operative Banks by Cooperative Banking

Regulation Act, 1949 and Banking Laws (Co-operative Societies) Act, 1965. The

RBI advisory group has opined that all the banks should be brought within the

purview of a single Act which prescribes the various practices to be followed by all

and one.

Lack of synchronization among various corporate governance norms: Three

different committees in India have dealt with the subject of corporate governance.

These are: the Kumar Mangalam Birla Committee Report, 2000 that had been

constituted by SEBI; CII Report, 1998 and the RBI advisory Committee Report,

2001. There is no synchronization of the regulations. Each report has dwelt on

specific issues. It would be better if a cormnon code is prescribed after harmonizing

the recommendations of various committees.

Qualitative vs. Quantitative: Banking norms are more quantitative than qualitative.

Governance depends more on quality of adherence to the norms in addition to

quantitative benchmark.

Mix up between ownership role and regulatory role: In most of the financial

institutions, the RBI has been a majority shareholder as well as the regulator.

Narsimhan Committee on Banking Reforms raised the question as to whether

regulators should be owners in the context of State Bank of India. Recently, RBI

vacated its majority ownerships from Financial Institutions like Securities Trading

Corporation of India Ltd. and Discount and Finance House of India and is in the

process of total disinvestment. There is also no justification for a regulator like RBI

to be represented on the Board of those regulated.

Mismatch between ownership pattern and board level representation: Previously,

Government used to be the majority shareholder in many of the financial

representation on its board. With divmified ownership, private shareholders have

begun to be given board level representation. But private shareholder representation

is not commensurate with the extent of their shareholding.

Lack of transparency in selection of board nrtkbers: It is anybody's guess as to

what are the considerations that weigh in making board level appointments. To have

truly professional directors, there should be a process of tbnsparent search.

Board Accountability: Accountability of Directors in Public Sector Banks is another

aspect on which processes have to be put in place. Directors must be made aware as

to what they are expected to do on the boards. Their actual performance should be

monitored and kept in view while reappointing them.

Lack of timely appointment of Directors: Sometimes it takes a number of years to

reconstitute the board of some of the public sector banks.

Political Boards: Very often, board level appointments in the financial institutions

are based on the political consideration. Board appointments must remain stable and

unaffected by political developments.

Banking Sector Restructuring in India

At the time of independence, India's financial system at the time of

independence was basically at limited services to cater to the demands of

international commerce credit needs of large trading and manufacturing houses.

India started to nationalize the largely private-sector ba'nks and concentrated them

into a few large government banks in the early years of post independence. The main

central bank, the Reserve Bank of India (RBI), was established and made

responsible for the co-ordination of nationalization and control plans. There were

three bouts of nationalization, one immediately after independence in 1949 with the

nationalization of the Imperial Bank of India, a second bout in 1969 and a third one

The State Bank of India (SBI) was granted a license in 1955, with the

objective to promote and expand SBI-affiliated banking facilities in the country and

to provide access to deposit and credit facilities to a large population base including

both rural and urban sectors. This resulted in a fast growth of the banking sector

with a large number of bank branches available across the country. Fourteen banks

were nationalized during the second rodd with eight more in March 1980. W e

structural result was that Indian banks moved from the private to the government

sector. Under government control the banks basically provided the payment function

but failed to develop the ability to assess and price investment risks. Later, the

private sector was allowed to participate and some licenses were granted to domestic

firms as well as foreign banks. This resulted in a mixed structure for the banking

sector in India with 22 large nationalized banks owned and operated by the

government, 29 domestic origin banks owned as joint-stock private companies and

24 foreign-origin banks.

The nationalized banks accounted for about 55 per cent of all retail banking

activities in the late 1980s. These banks also had the largest network of branches,

(61 per cent of the 61,000 branches in the country). It is surprising to see how the

much less powerful 29 privately-owned commercial banks and the 24 foreign-origin

banks managed to retain a 40 per cent share of the market in the 1990s! The Indian

financial sector was heavily regulatory which reduced the efficiency of the industry.

There were very high reserve requirements (at one time as high as 45 per cent of

deposits), which channeled deposits into the central bank. There were 20 different

schedules of interest rates. By controlling the minimum and maximum rates, the

regulators were able to subsidize some activities more than others. As a result, a

pervasive program of directing credits to certain economic activities developed.

The main banking sector reforms were implemented during 1992-94. The

aims of these reforms were to introduce greater transparency, to improve investor

protection, to enhance efficiency, to improve competition and to upgrade the

standards of customer service. The liberalization that started in India about thirteen

years ago has led to far-reaching changes in the financial structure. At present, India

has 53 private-sector banks, which represent about one third of all banking activities.

The Reserve Bank of India (RBI) supervises all of the above-mentioned

institutions and markets. It has direct responsibility for the licensing and supervision

of financial institutions and more generally the responsibility for the smooth

hnctioning of the entire financial system. In the pre-reform years of 1949-88, the

RBI played a critical role in implementing policies to support the diversion of

financial resources to the central govem&ent in order to carry out targeted credit

programmes to expand industrial capacity and agricultural outputs. Nowadays, the

RBI is more concerned with the deregulation of the financial sector, although

retaining responsibility for overall macroeconomic stability. All banks are now

required to extend credit to priority sectors, namely agriculture, small-scale

industries and small businesses, at concessionary interest rates. Up until 1990, this

directive applied to only the public sector banks but with deregulation this rule has

been extended to the private sector banks as an 'advisory' guideline. In addition, 1

per cent of credits are required to be made to certain sections (the scheduled caste

persons) of the community at a concessionary interest rate.

The government-owned banks, which still dominate the banking sector, are

now under pressure to improve operational efficiency to compete with new entrants

and now face increased scrutiny in relation to prudential norms. More private banks

are now being licensed to increase competition in order to improve customer service.

Some of the major reform measures undertaken are included. To sum up, India has

been able to significantly reform its banking sector, which is essential to sustainable

growth. However, with more active public and private banking sectors in place,

there is a need to implement some "self- discipline" measures, or corporate

governance guidelines.

How is Corporate Governance Different for Banks?

Banks are different fkom other corporates in important respects, and that

makes corporate governance of banks not only different but also more critical.

Banks lubricate the wheels of the real economy, are the conduits of monetary policy

transmission and constitute the &nomy's payment and settlement system. By the

very nature of their business, banks are highly leveraged. They accept large amounts

of uncollateralized public funds as deposits in a fiduciary capacity and further

leverage those hnds through credit creation. The presence of a large and dispersed

base of depositors in the stakeholders group sets banks apart fiom other corporates.

Banks are interconnected in diverse, complex and oftentimes opaque ways

underscoring their 'contagion' potential. If a corporate fails, the fallout can be

restricted to the stakeholders. If a bank fails, the impact can spread rapidly through

to other banks with potentially serious c&equences for the entire financial system

and the macro economy.

All economic agents tend to behave in a procyclical manner, and banks are

no exception, as aptly summed up by Chuck Prince, the former CEO of Citigroup,

who said that one had to keep dancing as long as the music was on! Where banks

differ is that their procyclical behaviour hurts not just the institution but the larger

economy. Among the many lessons of the crisis is the one that financial markets are

not self-correcting. This is in part because the signals of financial instability are

difficult to detect in real time. On top of that, banks escape some of the disciplinary

pressures of the market as their balance sheets are typically opaque.

Given the centrality of banks to modern financial systems and the macro

economy, the larger ones become systemically important. That raises a moral hazard

issue since systemically important banks will then spoil in excessive risk in the full

knowledge that all the gains will be theirs; and should the risks blow up, the

government or the central bank will bail them out and thereby the losses can be

socialized. Having collectively experienced the biggest financial crisis of our

generation over the previous years, we all know that these risks and vulnerabilities

of the financial system are not just text book concepts; they are all highly probable

real world eventualities.

If banks are 'special' in so many ways that I have indicated above, it follows

that corporate governance of banks has to be special too, reflecting these special

features. In particular, boards and senior managements of banks have to be sensitive

to the interests of the depositors, be aware of the potentially destructive

consequences of excessive risk .taking, be alert to warning signals and be wise

enough to contain irrational exuberance. Post-crisis, there is a debate on the extent to

which failure of corporate governance has been responsible for the crisis. Given

such overwhelming evidence of corporate governance failure, this is a fbtile debate.

The short point is this. If the directors on the boards of banks didn't know what was

going on, they should ask themselves if they were fit enough to be directors. If they

did know and didn't stop it, they were complicit in the recklessness and fraud. In

fact, the post-crisis verdict on corporate governance of banks is quite damning.

The Institute of International Finance, an association of major international

banks, has concluded aAer an examination of board performance of banks in 2008

that, "events have raised questions about the ability of certain boards to properly

oversee senior managements and to ~nderstand~and monitor the business itself'. As

per an OECD report, nearly all of the 11 major banks reviewed by the Senior

Supervisors Group (an informal group of senior supervisors under the auspice of the

Financial Stability Board - FSB) in 2008 failed to anticipate filly the severity and

nature of the market stress. On the positive side, there is some early evidence that

banks with stronger corporate governance mechanisms moderated the adverse

impact of the crisis on them, had higher profitability in 2008 and provided

substantially higher stock returns in the immediate aftermath of the market turmoil.

A relevant question in this context is whether there are any additional dimensions to

corporate governance of banks in emerging economies.

Indeed there are two important developments in this regard. First, in

emerging economies, banks are more than mere agents of financial intermediation;

they carry the additional responsibility of leading financial sector development and

of driving the government's social agenda. Second, in emerging economies, the

institutional structures that define the boundaries between the regulators and the

regulated and across regulators are still evolving. Managing the tensions that arise

out of these factors makes corporate governance of banks in emerging economies

even more challenging. (Dr. D. Subbarao, 201 1)

Best corporate governance practices will enable banks to

> Increase efficiency of theii activities and minimize risks;

P Get an easier access to capital markets and decrease the cost of capital;

> Increase growth rate;

> Attract strategic investors;

P Improve the standards of lending;

P Protect the rights of minority shareholder and other counterparts;

P Strengthen their reputation and raise the- level of investors and clients' trust,

(Desmond O'Maonaigh).

Objectives of Corporate Governance h Banks

Poor corporate governance may contribute to bank failures, which can pose

significant public costs and consequences due to their potential impact on any

applicable deposit insurance systems and the possibility of broader macroeconomic

implications such as contagion risk and impact on payment systems. In addition,

poor corporate governance can lead markets to lose confidence in the ability of a

bank to properly manage its assets and liabilities, including deposits, which wuld

turn, trigger a bank run air liquidity crisis. Generally, banks occupy a delicate

position in the economic equation of any. country such that its performance

invariably affects the economy of the country.

Objectives of corporate governance are establishing strategic objectives and

a set of corporate values that are communicated throughout the banking

organization; Setting and enforcing clear lines of responsibility and accountability

throughout the organization; Ensuring that board members are qualified to hold their

positions, have a clear understanding of their role in corporate governance and are

not subject to undue influence fiom management or outside concerns and Ensuring

that compensation approaches are consistent with the bank's ethical values,

objectives, strategy and control environment. (Ankit Katrodia)

Policy Framework of Corporate Governance in Indian Banking

Regulators are external pressure points for good corporate governance. Mere

compliance with regulatory requirements is not, however, an ideal situation in itself.

In fact, mere compliance with regulatory pressures is a minimum requirement of

good corporate governance and what are required are internal pressures, peer

pressures and market pressures to reach higher than minimum standards prescribed

by regulatory agencies. RBI's approach to regulation in recent times has some

features that would enhance the need for and usefblness of good corporate

governance in the banking sector. (V. Leeladhar 2004).

Committee Recommendations and Implementation

The global policy formulation on this issue can be traced to the industrialized

countries. Blue Ribbon Commission of US; Cadbury Committee from UK, and

many stock exchanges around the world started breaking governance principles and

the World Bank and OECD tried to give all the principles in a comprehensive

h e w o r k . India started its ground work for cg principle implementation after many

years of the implementation of Codes of Best Practices developed the Cadbury

Committee, 1 99 1 .

Considerable attention has been paid to corporate governance in India in

recent years. In addition to the Advisory Group chaired by Dr. R.H. Patil (RBI,

2001) and Consultative Group of Directors of Banks1 Financial Institutions

(Ganguly Group, RBI, 2002), several official Committees have already gone into the

issues relating to cg and have given their Reports. These include the Committee

chaired by Shri Kumar Mangalam Birla (SEBI, 1999), the Task Force on Corporate

Excellence through Governance (GOI, 2000), Naresh Chandra Committee on

Corporate Audit and Governance (SEBI, 2002), Naresh Chandra Committee-I1 on

Regulation of Private Companies and Partnership (GOI, 2003) and Narayana Murthy

Committee on Corporate Governance (SEBI, 2003). Recently, Malegam Committee

has gone into disclosure norms for offer documents (SEBI, 2004) that would also

contribute towards improving cg in the country. Preceding these official committees,

the industry association, CII, had itself provided a Code in 1998 (RBI, 2004).

Governance principle formulation exclusively for banking came a little late.

Although some regulations were issued by the Basel Committee on Banking

Supervision (BCBS) way back in 1988, these were not considered as exclusive cg

principles. The Basel banking reguIations issued in 1999, however, brought an array

of principles over a broad spectrum of banking activities. The OECD principles also

tried to fulfill some of the requirements of banking industry. Keeping in view the

widely accepted Base1 recommendations in the background many countries fiarned

their own set of governance piinciples for their banking industries. For Indian

banking the RBI has taken the sole responsibility of framing policy in this regard.

The Standing Committee on International Financial Standards and Codes which was

set up in 1999 to bring common financial standards in line with international

practices constituted an advisory committee on cg under the chairmanship of

R.H.Pati1. The sub-committee submitted its report in 2001 after reviewing the

governance models of East Asian countries, U.S., U.K., and other European

countries. (A.P Pati.)

The Report has observed that since most of the Indian companies belong to

the insider model of East Asia i.e. dominance of family/promoter ownership and

control, it is essential to bring quick reforms in the corporates/banks/financial

institutions/public sector enterprises to make them more autonomous and

professional (RBI,2001). The Group looked into public sector banks and noted that

the first important step to improve governance mechaniwn in these units is to

transfer the actual governance fbnctions from the concerned administrative

ministries to the boards and also strengthen them by streamlining them appointment

process of directors. Furthermore, as a part of strengthening the functioning of their

boards, banks should appoint a risk management committee of the board in addition

to the three other board committees viz., audit, remuneration and appointment

committees. Taking this move further, the Reserve Bank constituted a Consultative

Group of Directors of Banks and Financial Institutions (Chairman: Dr. A.S.

Ganguly) to review the supervisory role of Boards of banks and FIs. The Ganguly

Consultative Group looked into the hctioning of the Boards vis-A-vis compliance,

transparency, disclosures, audit committees and suggested measures for making the

role of the Board of Directors more effective (Gopinath, 2004).

Governance codes for banking are drawn from various committee reports as

mentioned in the above paragraph. Besides, Reserve Bank of India has taken various

steps furthering cg in the Indian Banking System. These can broadly be classified

into the following three categories viz. a) Transparency b) Off-site surveillance and

c) Prompt corrective action. Transparency and disclosure standards are also

important constituents of a sound cg mechanism. Transparency and accounting

standards in India have been enhanced to align with international best practices.

However, there are many gaps in the disclosures in India vis-d-vis the international

standards, particularly in the area of risk management strategies and risk parameters,

risk concentrations, performance measures, component of capital structure, etc. .

The off-site surveillance mechanism is also active in monitoring the

movement of assets, its impact on capital adequacy and overall efficiency and

adequacy of managerial practices in banks. RBI also brings out the periodic data on

Peer Group Comparison on critical ratios to maintain peer pressure for better

performance and governance. Prompt corrective action has been adopted by RBI as

a part of core principles for effective banking supervision. As against a dingle trigger

point based on capital adequacy normally adopted by many countries, Reserve Bank,

in keeping with Indian conditions, have set two more trigger points, namely, Non-

Paforming Assets @PA) and Return on Assets (ROA) as proxies for asset quality

and profitability. (A.P.Pati,)

Corporate Governance regulatory mechanisms in Banking Sector

The narrow approach of corporate governance views the subject as the

mechanism, through which shareholders are assured that managers will act in their

interests. (Shleifer and Vishny) (1997) define corporate governance as the methods

by which suppliers of finance control managers in order to ensure that their capital

cannot be expropriated and that they e m a return on their investment. Corporate

governance operates in a different context in banking sector compared to other

economic sectors. (Macey and O'Hara (2001) argue that a broader view of corporate

governance should be adopted in the case of banking institutions. They also argue

that because of the peculiar contractual form of banking, corporate governance

mechanisms for banks should include depositors as well as shareholders.

External Corporate Governance Mechanism

In common practices, depositors rely on the government role in protecting

their bank deposits fiom expropriating management. It might encourage economic

agents to deposit their h d s into banks because a substantial part of the moral

hazard cost is guaranteed by the government. In other wdrds, even if the government

may explicitly provide deposit insurance, bank managers probably still have an

incentive to opportunistically increase their risk-taking, however it will bear the

government's expense. This moral hazard problem can be restored through the use

of economic regulations such as asset restrictions, interest rate ceilings, reserve

requirements, and separation of commercial banking from insurance and investment

banking. The effects of these regulations limit the ability of bank managers to over-

issue liabilities or divert assets into high-risk ventures.

Thus, the special nature of banking requires not only a broader view of

corporate governance but also government intervention through regulation and

supervision in order to restrain the expropriating management behavior in banking

sector. In this view, managers and owners are subject to the regulation. (Caprio and

Levine, 2002). In general, the literature on bank regulation emphasises the a t 4

purpose of regulation as that of maintaining the integrity of the market system.

Recent attention is more focused on the role of government in the financial sector;

government's participation as the owner of financial intermediaries, government's

intervention in pricing and allocating credit, and governnlat's role in regulating and

supervising financial intermediaries. Regulation is commonly associated with the

resolution of market failure in provision of the public good of financial stability. The

characteristic limitations imposed are not wncerned with market structure. (for

examples barriers to entry or power of market monopoly). Instead, the constraints

imposed by bank regulators in many countries attempt the opposite action.

Ciancanelli and Gonzales (2000) state that in banking sector the regulation

and regulator represent external corporate governance mechanism. In the

conventional literature on corporate governance, the market is the only external

governance force with the power to discipline the agent. The existence of regulation

means there is an additional external force with the power to discipline the agent.

The force is quite different fiom the market. This implies that the power of

regulation has different effects fiom those produced by markets. Bank regulation

represents the existence of interests different from the private interests of the firm.

As a governance force, regulation aims to serve the public interests, particularly the

interests of the customers of the banking services. An agent of public interest, the

regulator, also enforces regulation itself. This agent d'oes not have a contractual

relationship either with the firm's principal or with the banking organisations

because of different interests from the principal (Ciancanelli and Gorizales 2000).

Internal Corporate Governance Mechanism

Although there is implicit government's guarantee to bailout bank deposit for

depositors of illiquid banks, the bailout process may take a lot of time. During the

waiting time to get their money, depositors have lost time value of money md

opportunities. Accordingly, they are willing to select banks which have credible

commitment to depositors. Hence, it does not only rely on external corporate

governance to force the management discipline, but also on the intention of bank

managers and owners to inform the market about their intentions to implement the

good corporate governance. This attention relies more on intemal side rather than on

external side, so-called internal corporate governance. Internal corporate governance

is about mechanism for the accountability, monitoring, and control of a h ' s

management with respect to the use of resources and risk taking (Llewellyn and

Sinha 2000).

The Basel Committee on Banking Supervision (1999) relies on the

responsibility of board directors and bank management on implementing good

corporate governance. Nam (2004) suggests sbme aspects that should be focused on

in the internal mechanism of corporate governance, including its independency and

structure, function and activity, compensation and other relevant responsibilities of

board of directors.

Reserve Bank of India

Traditionally, central banks have performed roles of currency authority,

banker to the Government and banks, lender of last resort, supervisor of banks and

exchange control (now it would be more appropriate to call it exchange

management) authority. Generally, central banks in developed economies have price

or financial stability as their prime objective and are often characterised by nearly

complete autonomy. Milton Friedman defines central bank relations with the

government as one that is comparable to the relation between judiciary and the

government. (Harvard University Press, 1962)

In developing countries the central bank plays a bigger role in the economy

and cannot reasonably be expected to have a total hands-off approach or be totally

independent of government; it has to nurture hand-hold and actively manage many

aspects of the economy. To that extent a central bank in a developing country plays

both a traditional and a non-traditional role that includes building independent

institutions such as capital markets, sector regulators, watchdogs, etc. and plays both

a regulatory and a development role. Central banking functions in India are carried

out by the Reserve Bank of India since independence by taking over the erstwhile

Imperial Bank of India formed in 1935. RBI was originally set up to regulate the

issue of currency, maintain foreign exchange reserves to enable monetary stabilitv

and generally to operate cmency and credit system in the country. As the economy

progressed, RBI's role underwent several shifts. For instance, when India followed a

control model of economic governance, RBI's monetary policy was focussed on

allocating resources to various sectors and maintaining price stability. A novel

mandate of RBI in its early stages was to finance five year plans, establishing

specialised institutions to promote savings and to meet the credit needs of the

priority sector.

RBI has been largely successful in its objectives of growth with stability,

developing India's banking and financial' sector and ensuring evolution of

competitive markets. Inevitably, because of the liberalisation process, Indian

banking sector is subject to greater shocks fkom external sources; for instance, a

market-based exchange rate system has integrated the Indian economy into the

global economy but the exchange rate has become more volatile.

The Main Functions of RBI

To act as regulator and supervisor of the financial system and prescribe

broad parameters of banking operations within which the country's banking and

financial system functions.

*:* To formulate, implement and monitor the monetary policy.

*:* To ensure adequate flow of credit to productive and priority sector.

9 To protect the interests of bank customers and public at large.

9 To control the monetary supply by issuing currency and regulating minimum

margins for various advances received by Banks (Cash Reserve Ratio,

Statutory Liquidity Ratio)

*:* To act as banker for the entire financial sector by lending1 accepting deposits

at the bank rate of interest.

+ To act as controller of credit i.e. it has .the power to influence the volume of

credit created by banks in India by chahging the Bank rate or through open

market operations. It can impose both quantitative and qualitative

restrictions.

*:* To monitor economic indicators and structure of the country for price

stabilisation and economic development.

*:* To control the banking system through the system of licensing, inspection

and calling for information.

*:* To facilitate external trade and payment and promote orderly development

and maintenance of foreign exchange market in India.

RBI's power of supervision and control over commercial and co-operative

banks relates to licensing, branch expansion, asset liquidity, management and

methods of working, amalgamation, reconstruction, and liquidation. The RBI is

authorized to cany out periodical inspections of banks and to seek returns and

necessary information. The Reserve Bank of India has the responsibility of

maintaining the official rate of foreign exchange and acts as the custodian of India's

reserve of international currencies.

RBI & Corporate Governance

Banks play a pivotal role in the financial and economic system of any

country. RBI plays a leading role in formulating and implementing corporate

governance norms for India's banking sector. The ambit encompasses safeguarding

and maximizing the shareholders' value, upholding retail depositors' risk and

stabilizing the financial system so as to conserve the larger interests of the public.

This role becomes important in view of the fact that in India bank assets often lack

transparency and liquidity because most bank loans, unlike other products and

services, are customized and privately negotiated. Banks are 'special' as they not

only accept and deploy large amount of uncollateralized public b d s in a fiduciary

capacity, but they also leverage such h d s +rough credit creation. They are also

important for smooth hctioning of the payment system. (RBI circular, 2004)

In case of instability of one bank owing to incompetent or unethical

management, the entire financial system and the economy may be impacted

adversely. As one bank becomes unstable, thqe may be a heightened perception of

risk among depositors for the entire class of suih banks, leading to early liquidation

and exposing the entire financial system to chaos. In such a situation, the interest of

borrowers (corporates, retail, etc.) mav also be affected in terms of availability of

credit, recall of credit lines and loss in valuation of mortgaged assets. Two main

features set banks apart fiom other business - the level of opaqueness in their

functioning and the relatively greater role of government and regulatory agencies in

their activities. The opaqueness in banking creates considerable information

asymmetries between the "insiders" - management - and "outsiders" - owners and

creditors. The very nature of the business makes it extremely easy and tempting for

management to alter the risk profile of banks as well as siphon off fund. (Rajesh

Chakrabarti)

The Reserve Bank of India performs corporate governance function under

the guidance of the Board for Financial Supds ion (BFS). Primary objective of

BFS is to undertake consolidated supervision of the financial sector comprising

commercial banks, financial institutions and non-banking finance companies. The

BFS was constituted in November 1994 as a committee of the Central Board of

Directors of the Reserve Bank of India. The Board comprises four directors of RBI

fiom Central board and is chaired by Governor. The Board is required to meet

normally once every month. It considers inspection reports and other supervisory

issues placed before it by the supervisory departments.

The BFS oversees the functioning of Department of Banking Supervision

(DBS), Department of Non-Banking Supervision (DNBS) and Financial Institutions

Division (FID) and gives directions on the regulatory and supervisory issues. BFS

inspects and monitors banks using the "CAMELS" (Capital adequacy, Asset quality,

Management, Earnings, Liquidity and Systems and controls) approach. BFS through

the Audit Sub-committee also aims at upgrading the quality of the statutory audit

and internal audit functions in banks and financial institutions.

Corporate Governance mechanism followed by RBI

Corporate Governance mechanism of RBI follows a three-pronged approach:

a) Disclosure and Transparency

b) Off-site surveillance

c) Prompt corrective action

a) Disclosure and transparency are the main pillars of a corporate governance

framework enabling adequate information flow to various stakeholders and

leading to informed decisions. ~ o c o u n t i n ~ standards in India in all sectors

including banking sector have been enhanced to align with international best

practices.

b) The off-site surveillance mechanism monitors the movement of assets, its impact

on capital adequacy and overall efficiency and adequacy of managerial practices

in banks. RBI promotes self- regulation and market discipline among the

banking sector participants and has issued prudential norms for income

recognition, asset classification, and capital adequacy. RBI brings out periodic

data on 'Peer Group Comparison' on critical ratios to maintain peer pressure on

individual banks for better performance and governance.

c) Prompt Corrective Action is a supervisory mechanism implemented as part of

Effective Banking Supervision in terms of Basel I1 requirements. It is based on a

pre-determined rule based structure of early intervention whereby benchmark

ratios for three parameters Capital Adequacy Ratio, Non-Performing Assets

Ratio and Return on Assets are determined. Any breach of these trigger points is

considered as early warning on the financial health of the banks and appropriate

mandatory or discretionary action is initiated by the RBI (RBI circular 2001)

RBl's Corporate Govemapce Mechanism

Other Corporate Governance Mechanisms

a) Apart from working under the jurisdiction of RBI as mentioned above, listed

banks, Non-Banking Finance Companies and other financial intermediaries are

governed by SEBI' s clause 49 on corporate governance.

b) Additionally, RBI has also issued various circulars and notifications that provide

guidelines on:

> Composition, QuaIification, Independence and Remuneration of Board of

Directors.

P Roles, Responsibilities and Training of Executive Directors.

P Resolution of Conflict of Interest in the case of related party transactions.

> Constitution of Nomination Committee, Risk Management Committee and

Audit Committee.

Basel Committee

The Base1 Committee on Banking Supervision (the Committee) has had a

longstanding commitment to promoting sound corporate governance practices for

banking organisations. It published initial guidance in 1999, with revised principles

in 2006, chaired by Mr. Roger Cole - Federal Reserve Board, Washington, D.C. The

Committee's guidance assists banking supeivisors and provides a reference point fhr

promoting the adoption of sound corporate governance practices 'by banking

organisations in their countries. The principles also serve as a reference point for the

banks' own corporate governance efforts.

The Base1 Committee has recently issubd several papers on specific topics,

where the importance of corporate governance is emphasised. These include

Principles for the management of interest rate risk ( ~ e p t h b e r 1997), Framework for

internal control systems in banking organisations (September 1998), Enhancing

bank transparency (September l998), and Principles for the management of credit

risk (issued as a consultative document in July 1999). These papers have highlighted

the fact that strategies and techniques that are basic to sound corporate governance

include :( A. C. Fernando)

P The corporate values, codes of conduct and other standards of appropriate

behaviour and the system used to ensure compliance with them;

P A well-articulated corporate strategy against which the success of the overall

enterprise and the contribution of individuals can be measured;

> The clear assignment of responsibilities and decision-making authorities,

incorporating a hierarchy of required approvals fiom individuals to the board of

directors;

> Establishment of a mechanism for the interaction and cooperation among the

board of directors, senior management and the auditors;

R Strong internal control systems, including internal and external audit functions,

risk management functions independent of business lines, and other checks and

balances;

> Special monitoring of risk exposures where conflicts of interest are likely to be

particularly great, including business relationships with borrowers affiliated with

the bank, large shareholders, senior management, or key decision-makers within

the firm (e.g. traders);

> The financial and managerial incentives to act in an appropriate manner offered

to senior management, business line management and employees in the form of

compensation, promotion and other recognition; and

> Appropriate information flows internally and to the public.

The reality that various corporate governance structures exist in different

countries reflects that there are no univnSally correct answers to structud issues

and that law need not be consistent from country to country. Acknowledging this,

sound governance can be practiced regardless of the form used by a banking

organisatian. There are four important forms of oversight that should be included in

the organisational structure of any bank in order to &sure the appropriate checks

and balances: (1) oversight by the board of directors or supervisory board; (2)

oversight by individuals not involved in the day-to-day running of the various

business areas; (3) direct line supervision. of different business areas; and (4)

independent risk management and audit functions. In addition, it is important that

key personnel are fit and proper for their jobs. Government ownership of a bank has

the potential to alter the strategies and objectives of the bank as well as the internal

structure of governance. Consequently, the general principles of sound corporate

governance are also beneficial to government-owned banks.

Sound corporate governance practices

As mentioned above, supervisors have a keen interest in determining that

banks have sound corporate governance. The following discussion draws on

superviso~y experience with corporate governance problems at banking

organisations and suggests the types of practices that could help to avoid such

problems. These practices should be viewed as critical elements of any corporate

governance process. Establishing strategic objectives and a set of corporate values

that are communicated throughout the banking organisation. It is difficult to conduct

the activities of an organisation when there are no strategic objectives or guiding

corporate values. Therefore, the 'board should establish the strategies that will direct

the ongoing activities of the bank. It should also take the lead in establishing the

"tone at the top" and approving corporate values for itself, senior management and

other employees. The values should recognise the critical importance of having

timely and frank discussions of problems. In particular, it is important that the values

prohibit corruption and bribery in corporate activities, both in internal dealings and

external transactions.

The board of directors should ensure that senior management' implements

policies that prohibit (or strictly limit) aitivities and relationships that diminish the

quality of corporate governance, such as:

> Conflicts of interest;

P Lending to officers and employees and other forms gf self-dealing (e,g., internal

lending should be limited to lending consistent with market terms and to certain

types of loans, and reports of insider lending should be provided to the board,

and be subject to review by internal and external auditors); and

> Providing preferential treatment to related parties and other favoured entities

(e.g., lending on highly favorable terms, covering trading losses, waiving

commissions). Processes should be established that allow the board to monitor

compliance with these policies and ensure that deviations are reported to an

appropriate level of management.

\u Setting and enforcing clear lines of responsibility and accountability throughout

the organisation. Effective boards of directors clearly define the authorities and

key responsibilities for themselves, as well as senior management. They also

recognise that unspecified lines of accountability or confusing, multiple lines of

responsibility may exacerbate a problem through slow or diluted responses.

Senior management is responsible for creating an accountability hierarchy for

the staff, but must be cognisant of the fact that they are ultimately responsible to

the board for the performance of the bank.

P Ensuring that board members are qualified for their positions, have a clear

understanding of their role in corporate governance and are not subject to undue

influence from management or outside concerns.

The board of directors is ultimately responsible for the operations and

financial soundness of the bank. The board of directors must receive on timely basis

sufficient information to judge the performance of management. An effective

number of board members should be capable of exercising judgment, independent of

the views of management, large shareholders or governments. Including on the

board qualified directors that are not members-of the bank's management, or having

a supervisory board or board of auditors separate from a management board, can

enhance independence and objectivity. Moreover, such members cari bring new

perspectives fkom other businesses that may improve the strategic direction given to

management, such as insight into local conditions. Qualified external directors can

also become significant sources of management expertise in times of corporate

stress. The board of directors should periodically assess its own performance,

determine where weaknesses exist and, where possible,. take appropriate corrective

actions.

Boards of directors add strength to the corporate governance of a bank when

they: understand their oversight role and their "duty of loyalty" to the bank and its

shareholders;

P Serve as a "checks and balances" function vis-hvis the day-to-day management

of the bank;

P Feel empowered to question management and are comfortable insisting upon straightforward explanations from management;

P Recommend sound practices gleaned from other situations;

P Provide dispassionate advice; are not overextended;

P Avoid conflicts of interest in their activities with, and commitments to, other

organisations;

> Meet regularly with senior management and internal audit to establish and approve policies, establish communication lines and monitor progress toward

corporate objectives;

P Absent themselves frorr decisions when they are incapable of providing

objective advice;

Do not participate in day-to-day management of the bank.

P In a number of countries, bank boards have found it beneficial to establish

certain specialized committees including:

P A Risk management committee - providing oversight of the senior management's activities in managing credit, market, liquidity, operational, legal and other risks of the bank. (This role should include receiving from senior

management periodic information on riek exposures and risk management

activities).

P An Audit committee - providing oversight of the bank's internal and external

auditors, approving their appointm&t and dismissal, reviewing and approving

audit scope and frequency, receiving their reports and ensuring that management

is taking appropriate corrective actions id.a timely manner to address control

weaknesses, non-compliance with policies, laws and regulations, and other

problems identified by auditors. The independence of this committee can be

enhanced when it comprises exttmal board members that have banking or

financial expertise.

P A Compensation committee - providing oversight of remuneration to senior

Management and other key personnel and ensuring that compensation is

consistent with the bank's culture, objectives, strategy and control environment.

& A Nominations committee - providing important assessment of board

effectiveness and directing the process of renewing and replacing board

members.

Ensuring that there is appropriate oversight by senior management. Senior

management is a key component of corporate governance. While the board of

directors provides checks and balances to senior managers, similarly, senior

managers should assume that oversight role with respect to line managers in specific

business areas and activities. Even in very small banks, key management decisions

should be made by more than one person ("four eyes principle"). Management

situations to be avoided include:

Senior managers who are overly involved in business line decision-making;

> Senior managers who are assigned an area to manage without the necessary

prerequisite skills or knowledge;

> Senior managers who are unwilling to exercise control over successful, key

employees (such as traders) for fear of losing them.

Senior management consists of a core group of officers responsible for the

bank. This group should include such individuals as the chief financial officer,

division heads and the chief auditor. These individuals must have the necessary

skills to manage the business under their supervision as well as have appropriate

control over the key individuals in these areas.

Effectively utilising the work conducted by internal and external auditors, in

recognition of the important control function they provide.

The role of auditors is vital to the-corporate governance process. The

effectiveness of the board and senior management can be enhanced by: (1)

recognising the importance of the audit process and communicating this importance

throughout the bank; (2) taking measures that enhance the independence and stature

of auditors; (3) utilising, in a timely and effective manner, the findings of auditors;

(4) ensuring the independence of the head auditor through his reporting to the board

or the board's audit committee; (5) engaging external auditors to judge the

effectiveness of internal controls; and (6) requiring timely correction by

management of problems identified by auditors.

The board should recognise and acknowledge that the internal and external

auditors are their critically important agents. In particular, the board should utilise

the work of the auditors as an independent check on the information received from

management on the operations and performance of the bank. Ensuring that

compensation approaches are consistent with the bank's ethical values, objectives,

strategy and control environment. Failure to link incentive compensations to the

business strategy can cause or encourage managers to book business based upon

volume and/or short-term profitability to the bank with little regard to short or long-

term risk consequences. This can be seen particularly in the case of with traders and

loan officers. But can also adversely affect the performance of other support staff.

The board of directors should approve the compensation of members of

senior management and other key personnel and ensure that such compensation is

consistent with the bank's culture, objectives, strategy and control environment. This

will help to ensure that senior managers and other key personnel will be motivated

to act in the best interests of the bank. In order to avoid incentives being created for

excessive risk-taking, the salary scales should be set, within the scope of general

business policy, in such a way that they do not overly depend on short-term

performance, such as short-term trading gains. Conducting corporate governance in

a transparent manner.

AS set out in the Basel Committee's paper, enhancing bank transparency, it is

difficult to hold the board of directors and senior management properly accountable

for their actions and performance when there is a lack of transparency. This happens

in situations where the stakeholders, market pikicipants and general public do not

receive sufficient information on the structure and objectives of the bank with which

to judge the effectiveness of the board and senior m&agement in governing the

bank. Transparency can reinforce sound corporate governance. Therefore, public

disclosure is desirable in the following areas:

P Board structure (size, membership, qualifications and committees);

P Senior management structure (responsibilities, reporting lines, qualifications and

experience);

P Basic organisational structure (line of business structure, legal entity structure);

P Information about the incentive structure of the bank (remuneration policies,

executive compensation, bonuses, stock options);

P Nature and extent of transactions with affiliates and related parties.

Dr. Ashok Ganguli

At the initiative of the RBI, a consultative group, aimed at strengthening

corporate governance in banks, headed by Dr. Ashok Ganguli was set up to review

the supervisory role of Board of banks. The recommendations include the role and

responsibility of independat non-executive directors, qualification and other

eligibility criteria for appointment of non-executive directors, training the directors

and of ensuring that they keep abreast of latest developments. In private sector

banks, etc. It is unanimously accepted that the most crucial aspect of corporate

governance is that the organisation have a professional board which can drive the

organisation through its ability to perform its responsibility of meeting regularly,

retaining full and effective control over the company and monitor the executive

management. Some of the important recommendations on the constitution of the

Board are:

* Qualification and other eligibil ity criteria for appointment o f non-executive

directors,

*:* Defining role and responsibilities o f directors including the recommended

"Deed o f Covenant" to be executed by the bank and the directors in conduct

o f the board functions.

Training the directors and keeping them abreast o f the latest developments.

(V. Leeladhar 2004)

Corporate governance policy implementation in India

Looking at the developments o f governance practices and i ts

implementations in India i t is found that till the year 2002 most o f them were at

recommendatory stage. Most o f the suggestions given by the Advisory Group (2001)

and Ganguly Committee (2002) were implemented during and after the year 2002.

The fol lowing paragraphs hghlight the status o f bank governance as envisaged by

the Advisory Group (2001), their recommendations, and the action taken by RBI for

their implementation.

Table.4.1 : Governance status in Indian Banking I

Governance Variables

1.Responsibility of the Board

2. Accountability of The Board to shareholderslstak eholders

Governance Status, 2001

Board members not effective as ideally envisaged. This is more visible in PSU banks.

Boards of majority of the banks do not fulfill clear lines of responsibility and accountability for themselves.

Committee recommendation

areBoards to Align responsibilitis in Line with international best practices. Boards are to play very active role in providing oversight to senior level management for managing different risks. Limits for individual voting rights are 1 per cent in PSBs, but 10 per cent for private sector banks.

The board should be Accountable to the Owners of the bank. The bank should also keep in view the interests of main stakeholders, such as, depositors, employees, creditors, customers, etc.

Action Taken By RBI Between 2002 and 2004

theirRecommendations of the Ganguly Group have been forwarded for implementation. Directors to execute the deed of covenants to discharge their responsibilities to the best of their abilities, individually and collectively.

The Chairman of the Audit Committee should be present at AGMs to answer Shareholder queries. Banks have also been Advised to form committees under the chairmanship of a executive director to look into the redressal of complaints. -

3. Election to the board

PSU the board formed by the Government and through nomination. In private sector banks appointments are Governed by Banking Regulations Act, and the companies Act. One director each is nominated to the boards of private sector banks by RBI.

The sizes of the l Boards of PSU banks are stipulated by Their respective statutes.

Not less than one half of the total number of directors of banks shall consist of persons who have

&

4. Size of the Board

5.Composition of the Board

6. Independence of directors

7.Tenure for Directors and Age

.

All banks should have minimum of 10 board members. Increasing number Of professionals on Boards by specifying proportion of non executive members on Boards as in the case of other companies. Banks should have a specified proportion as non-executive independent directors as in the case of other companies.

The process of selection with clear and transparent criteria. Such criteria for choosing non- executive directors should be disclosed in the Annual Report. They should be independent and elected and have different tenures to ensure continuity. For appointments1 renewal of appointments to Board. They should undertake a process of due diligence in regard to the suitability for the appointment of directors. The Boards of banks should form nomination committees to scrutinize declarations of candidates. Apprised GO1 on this issue and the matter is being followed up by the Concerned agencies. RBI direction on board Appointments has been issued.

The Ganguly Committee Recommendations are communicated to banks.

Issued circular annexing the Mandatory recommendations of the SEBl Committee on Corporate Governance. It implies that in case a company has a non- executive Chairman, at least half of the Board should be independent.

Wholetime Directors should have sufficiently long tenure. As per Banking Regulation Act, maximum tenure of non- executive Directors are eight years. Stipulated age limit of 35-65 years for Non-executive Directors. The upper age limit has since been revised to 70 years.

special knowledge or practical experience.

Disclosure The interest is mandatory, in the case of conflict of interest arising, the director has to Abstain from the Decision making

No mandatory provisions.

Representation of private shareholders is required in the case of mixed ownership. The recommendation of Blue ribbon commission shall be applicable. The directors nominated by the government on the boards of PSBs and all nominees of the regulators should not be considered as independent. A majority of non-executive directors should be identified in the Annual Report. Tenure for independent Directors may preferably be up to ten years at a stretch. The age limit should be a maximum of 65 years for whole-time Directors and 75 years for part-time Directors. The liability of non-executive directors shoClld be limited.

Source : Report of the Advisory Group, 2001, RBI and Report of the Consultative Group of Directors of banks and financial institutions, RBI, 2004..

. 8.Multiple Board seats

9.Chairman and CEO:

10.Board Meetings

1 1. Disclosure of Director Biographical Information

12.Disclosure of remuneration

13.Audit Committee

14.Remunerat ion Committee

15.Financial reporting, Disclosure and Transparency

A person cannot be on the boards of two banking companies simultaneously.

The Government controls the appointment Ndionalised banks to hold at least six meetings in a year and at least once in a quarter.

No specific provision.

A number of banks do not disclose the entire compensation package of their full time directors. Banks are yet to set up audit committee with right composition of various directors. No provision.

Standard of banks disclosure falls short of international standard. Some disclosures are made mandatory by RBI.

One Director should not serve *on more than 10 Boards or ' be member of more than 5-6 committees,

Chairman and CEO should be separated positions

. At least six meetings in a year keeping aside the quarterly restrictions.

Details abod the new director should be given in the general meeting of shareholders and also in the Annual Report.

Remuneration package of the directors should be disclosed in the Annual Report and they should be reported to shareholders and audited. Audit Committees should be formed as per recommendations of the Blue Ribbon Committee.

Boards should set up Remuneration Committees made up exclusively of non executive Board members. Remuneration should be decided by the remuneration committee. Financial reporting, disclosure and transparency of banks need further improvement. Disclosures as per accounting standards should cover subsidiaries, especially where 26 per cent or more shareholding exists. Disaggregated segmental information should also be provided.

RBI has issued circular in June 2002 directing that a Director should not b in more than 10 committees or act as a Chairman on more than 5 committees. Requested GO1 for legislative changes as the per Ganguly Group recommendation. Made mandatory that Board meetings be held at least 4 times a year with a maximum gap of 4 months.

Prescribed appropriate procedures for nomination. Disclosure for key management personnel in accordance with Accounting Standards 18.

Audit Committee should have independent non executive Directors and Executive Director should only be a permanent inviiee. Written to GO1 for making necessary legislative changes.

Asked banks to include separate section on cg in their Annual Reports. Made mandatory for banks to adopt all accounting standards that are required to be followed, though certain flexibility required by banks has been provided for.

Measures Taken By Banks towards Implementation of Best Practices

Prudential norms: In terms of income recognition, asset classification, and capital

adequacy have been well assimilated by the Irfdian banking system. In keeping with

the international best practice, starting 31st March 2004, banks have adopted 90

days norm for classification of NPAs. Also, norms governing provisioning

requirements in respect of doubtful assets have been made more stringent in a

phased manner. Beginning 2005, banks will be required to set aside capital charge

for market risk on their trading portfolio of government investments, which was

earlier virtually exempt from market risk requirement.

Capital Adequacy: All the Indian banks barring one today are well above the

stipulated benchmark of 9 percent and remain in a state of preparedness to achieve

the best standards of CRAR as soon as the new Base1 2 norms are made operational.

In fact, as of 3 1 st March 2004, banking system as a whole had a CRAR close to 13

per cent.

On the Income Recognition Front, there is complete uniformity now in the

banking industry and the system therefore ensures responsibility and accountability

on the part of the management in proper accounting of income as well as loan

impairment.

ALM and Risk Management Practices - At the initiative of the regulators, banks

were quickly required to address the need for Asset Liability Management followed

by risk management practices. Both these are critical areas for an effective oversight

by the Board and the senior management which are implemented by the Indian

banking system on a tight time frame and the implementation review by RBI. These

steps have enabled banks to understand, measure and anticipate the impact of the

interest rate risk and liquidity risk, which in deregulated environment is gaining

importance. (V. Leeladhar 2004)

Status of Indian Banking Industry in Global View

It is useful to note some telling facts about the status of Indian banking

industry when compared with other countries, recognising differences between

developed and emerging economies.

160

First, the structure of the industry: the number of large and medim domestic

banks, defined as the number of banks ranked in the world's top1000, tends to be

much larger in developed countries as compared with emerging economies.

Illustratively, as at the end of 1998, the number of such banks was 198 and 1 16 in

the US and Japan respectively as compared with 8 in Argentina, 22 in Brazil and 11

in India. This is perhaps reflective of differences in. sizes of economy and the

financial sector. '

Second, the share of bank asset in total financial sector assets. In most

emerging markets, banking sector assets winprise well over 80 per cent of total

financial sector assets, whereas these figures are much lower in developed

economies. In India, the share of banking assets in total financial sector assets is

around 75 per cent, as of end-March 2004. There is, thus, merit in recognising the

importance of diversification in the institutional and instrumental aspects of

financial intermediation in the interests of wider choice, competition and stability.

However, the dominant role of banks in financial intermediation in emerging

economies, in particular India will continue in the medium-term; and banks will

continue to be special for a long time in future.

Third, industry concentration, measured by the percentage of a country's

banking sector assets controlled by the largest banks. In most emerging market

economies, the five largest banks (usually domestic) account for over two-thirds of

bank assets. These figures tend to be much lower in developed economies.

Illustratively, for 2004, in India, the said percentage is 0.41. In 2001, the

corresponding figures were 9.33 for New Zealand, 0.28 for Italy and 0.27 for the

United States. This is an interesting factor that should be borne in mind while

considering the way forward in consolidation of banking sector in India.

Fourth, internationalization of banking operations. As per cent of total

domestic assets, foreign-controlled assets increased significantly in several European

countries (Austria, Ireland, Spain, Germany and Nordic countries), but increases

have been fairly small in others (UK and Switzerland). Among emerging economies,

while there were marked increases of foreign-controlled ownership in several Latin

American economies, the increase has, at best, been modest in East Asian

economies. Available evidence seems to. indicate some correlation between the

extent of liberalisation of capital account in emerging markets and share of assets

controlled by foreign banks. As per evidence available, the foreign banks in Jndia

who are present in the form of branches seem to enjoy greater fieedom in their

operations including retail banking in the country virtually on par with domestic

banks, compared to most other developing countries. Further, the profitability of

their operations in India is considerably higher than those of domestically-owned

banks and, in fact, is higher than h e foreign banks operating in most other

developing countries. India continues to grant branch licenses more liberally than

the WTO commitments.

Finally, the share of state-owned banks in total banking sector assets.

Emerging economies, with predominantly Government-owned banks, tend to have

much higher state-ownership of banks as compared with their developed

counterparts. While many emerging countries choose to privatise their public sector

barking industry, after a process of absorption of overhang problems by the

Government, we have encouraged state-run banks to diversify ownership by

inducting private share capital and absorb the overhang problems. The process has

helped reduce burden on Government, improve efficiency as reflected in stock

market valuation, promote new efficient private sector banks, while drastically

reducing the share of public sector banks wholly owned by Government in a rapidly

growing industry. Our successful reform of public sector banks is an excellent

example of a dynamic mix of public and private ownership in banks.

Another notable difference between the consolidation processes in developed

versus emerging markets is the overwhelming cross-border nature of mergers and

acquisitions in the latter. In particular, cross-border merger activity in continental

Europe and also between US and European institutions has been more an exception

rather than the rule. In contrast, there has been a perceptible increase in foreign

ownership of emerging market banks. In this regard, it is useful to recognise that

consolidation, in particular expansion of foreign ownership in many emerging

countries was a consequence of crisis. In transition economies, it was part of overall

market action, including prospects of joining European Union. Our opening of

banking sector to the foreign banks through branches is not on account of crisis, but

by deliberate policy choices.

Indian Banking Challenges Ahead

Let me highlight some thoughts on certain areas which have a key bearing on

the ability of Indian banks to remain competitive and enhance soundness. Needless

to state, these are more in the nature of random thoughts, rather than any structured

thinking, and are meant to invite your attention.

First, Cost management. Cost containment is a key to sustainability of bank

profits and their long-term viability as well. To highlight this point, let me, take

recourse to some figures. In 2003, operating costs of banks as percent of total

average asset [i.e., total asset at the beginning of the year plus total asset at the

beginning of the subsequent year)/2] in UK were 2.12, for those in Switzerland they

were 2.03 per cent, and less than 2 per cent in major European economies like

Sweden, Austria, Germany and France. In India, in 2003, operating costs as per cent

of total asset of scheduled commercial banks were 2.24 per cent. The tasks ahead are

thus clear and within reach.

Second, Recovery management. This is a key to the stability of the banking

sector. There should be no hesitation in stating that Indian banks have done a

remarkable job in the containment of non-performing loans (NPL) considering the

overhang issues and overall difficult environment. The process would, however,

need to be pursued in right earnest, while persisting with changes in legal,

institutional and procedural aspects to bring about a conducive environment for

banks' operations. In 2003, non-performing loans to total loans of banks were 1.2

per cent in US, 1.4 per cent in Canada and in the range of 2-5 per cent in major

European economies; France was an exception at 4.9 per cent. In contrast, the same

for Indian banks was 8.8 per cent and that for Chinese state-owned banks was 22.0

per cent. Let me add that the 2004 gross NPL ratio for Indian scheduled commercial

banks at 7.3 per cent is ample testimony to the impressive efforts being made by our

banking system. In fact, recovery management is also linked to banks' interest

margins. Net interest margins of scheduled commercial banks in India was 2.8 per

cent in 2003, whereas it stood far lower in the range of 0.6-2.4 percent at major

European and Japanese banks. Clearly, cost and recovery management supported by

enabling legal framework holds the key to fbture competitiveness of Indian banks.

Third, Technological intensity of banking. This is one area where perhaps

India needs to do significant 'catching up', notwithstanding the rapid strides made

over the last few years, though data on this score are difficult to come by. Some

available figures indicate that in late 1999, the percentage of customers using online

banking was less than 1 per cent in India, compared with anywhere between 6-30

per cent in devel~ped economies like ITS, UK, Germany, Finland and Sweden. Even

in Latin America, these figures are much higher than India's. While admittedly the

numbers for India are likely to be much higher at present than these figures suggest,

so would be the case for these other economies as well. The issue, therefore, remains

what has been the extent of 'catching up' by India on this score? In fact, this seems

somewhat intriguing: India happens to be a world leader in information technology,

but its usage by our banking system is somewhat muted. It is wise for Indian banks

to exploit this globally state-of-the art expertise, domestically available, to their

hllest advantage.

Fourth, Risk Management. Banking in modern economies is all about risk

management. The successfil negotiation and implementation of Basel I1 is likely to

lead to an even closer focus on risk measurement and risk management at the

institutional level. Thankfully, Base1 I1 has, through their various publications,

provided useful guidelines on managing the various facets of risk. The institution of

sound risk management practices would be an important pillar for remaining ahead

of the increasing competition. Banks can, on their part, formulate 'early warning

indicators' suited to their own requirements, business profile and risk appetite in

order to better monitor and manage risks.

Fifth, Governance. The recent irregularities involving accounting firms in the

US have amply demonstrated the importance of good corporate governance

practices. The quality of corporate governance in the banks becomes critical as

competition intensifies, banks strive to retain their client base, and regulators move

out of controls and micro-regulation. No doubt, there is nothing like an 'optimal'

level of governance for one to be satisfied. (V. Leeladhar 2004).

164

The Impact of Regulation on Governance

Since banks are key players in national payment and credit systems, and due

to fears of contagion, virtually all governments energetically regulate and supervise

banks. To be sure, formal comparisons of the 'degree of regulation' between banks

and nonfinancial firms are not straightforward. It is true that some industries, such as

nuclear power, also are heavily regulated, due no doubt to concerns about a different

type of fallout. But, even governments that intervene little in other sectors heavily

regulate banking. Moreover, the explosion of international standards in banking

attests to the great degree of official involv&ent. The heavy hand of regulation not

only results from banks being different - in many ways due to their opacity - but

also results in making banks and their corporate governance different. In this section

we review how regulation affects the different channels for corporate governance.

Strategy for Improving Governance in Banks

Existing research (BCL, 2001) shows that countries in which the government

supports the ability of private sector entities to monitor banks, permits banks to

engage in a wide-range of activities, allows in foreign entities, minimizes state

ownership, and encourages diversification, enjoy better developed financial systems

with a lower likelihood of serious financial crisis. Stated differently, the

government's job can be seen as trying to foster the ability and incentive of all the

different potential monitors of banks to do their jobs well. This research does not

imply that efforts to improve bank supervision are nugatory, but rather that they

need to be focused on supporting the private sector, instead of trying to rephrase it

with public sector. Existing research thus suggests a strategy for authorities seeking

to improve governance in banking.

As a first step, it is critical that governments recognize and curb any of their

own behaviors that thwart the private sector's ability and incentive to monitor banks.

Thus, for example, in countries in which government ownership is pronounced,

private sector monitoring cannot be expected, and competitive forces clearly are

blocked. Moreover, as argued above, government supervision of government banks

also cannot be expected to be thorough and independent. In these cases, embarking

on a program to reduce government ownership where it is pronounced would seem

to be essential; without this step it is difficult to conceive of the success of other

efforts to ameliorate the governance problem. Countries with blanket deposit

insurance, or extremely generous deposit instqance coverage (certainly the levels of

10 to 15 times per capita GDP that are found in very low income countries) also are

sure to be those in which private sector monitoring is virtually nonexistent.

Reducing such coverage to much lower levels also would be essential in order to

enhance private sector monitoring.

A second step in improving governance in banking involves directly

reducing the opacity of banks by improving the flow of information. Although

transparency of banking information in emerging markets is receiving increased

attention in the wake of the East Asian crisis (and perhaps more so in the aftermath

of the Enron collapse), the likely reinforcement of opacity by existing ownership

patterns in emerging markets suggests that this task is even more important and yet

more difficult than has been recognized. In effect, authorities will need to engage in

the unpopular task of shaking-up cozy relationships among powerful interest groups

in their society.

This task is not as simple as it because mere superficial adherence to

international standards will not take baking system forward; rather? it is a process

that will require sustained commitment over a period of time in order to take effect.

In addition to much greater attention to improving accounting and auditing,

improvements to credit information will facilitate the expansion of banking by those

interested in providing finance to groups that were previously excluded. Enhancing

corporate finance reporting in the media, and education as to the importance of this

issue in a wide swath of civil society, will help make a lasting contribution to better

corporate governance. This is not easy: the same family groups that control banks

may also control the media, so broader antitrust activity may be necessary in order to

make this work. Moreover, it is worth stressing again that these changes will not

happen to the extent that governments underwrite risk.

Third, although better information may indirectly enhance the contestability

of the banking market and invigorate the market for corporate control in banking,

opening to foreign banks offers a direct mechanism for creating competitive

pressures in banking. BCL (2001) found .that it was not so much the presence of

foreign banks as the contestability of markets (associated with relative openness to

foreign entry) that contributed to the development and stability of emerging market

banking. Foreign banks, and indeed foreign ,entry in other markets, will serve to

increase the competitiveness of the economy in general and lessen the reliance on

family or conglomerate relationships. Clarke, Cull, and Martinez-Peria (2001) also

show that increased foreign presence in emerging market banking has the attractive

benefit of improving access to credit, even by small and medium-sized enterprises.

The resulting increase in competition in the economy can pay dividends in the long-

term to the corporate governance problems djscussed here. Clearly the same should

apply to foreign competition in insurance and pension management.

Fourth and most importantly, the potential monitors of banks - owners,

markets (large creditors in particular) and supervisors - need clear and strong

incentives to do their jobs well. As stressed above, the legal and bankruptcy systems

do not operate well in many countries. Thus, bank managers can control banks with

little to fear from outside investors, or even fi-om bankruptcy as is clearly evident

from Japan's ten-year banking crisis. Owners, particularly controlling shareholders,

will have the incentive to monitor their banks well (meaning in accordance with

society's goals), only to the extent that their own resources are really at risk and to

the extent that there are healthy profits in return for safe and sound banking.

Unfortunately, ensuring that capital is real and that weak lending practices have not

eroded is not simple in practice.

The incentives to be offered to insider owners and managers can be enhanced

in a number of ways. The ability of authorities to influence inside owners and

managers is enhanced if regulators can impose penalties when there is evidence of

fraud or of improper conduct. Similarly, the incentives of inside owners and

managers will clearly be enhanced if small shareholders and debtors can confidently

use an efficient court system that supports their rights. More generally, regulation

has not focused much attention on compensating of senior managers. For example,

an attempt to vary capital requirements in line with the extent to which banks'

compensation policies encourage or discourage excessive risk taking is a promising

area for new research.

The supervisory process in some countries is getting close to this issue when

supervisors examine the systems that banks-have in place for managing their risks.

We suspect that as important as risk manag.ement is as a process, the incentives

inside the individual banks for taking risk 'will determine the efficacy of any

processes that are written down. Macey and O'Hara (2001) propose, as an adjunct to

the standard Anglo-American model of wrporate governance, an expanded set of

fiduciary duties for the bank corporate officers and directors, stimulated perhaps by

the creation of long-term stakeholders that characterizes the so-called Franco-

German model. Certainly, the threat of legal recourse for those who suffer losses

when directors do not fulfill their fiduciary duties would improve the incentives for

this group, and it might also encourage them to support reforms in compensation

policies for senior bank officers.

Compensation policies of directors themselves also demand greater attention

and fUrther research into the extent to which bank and corporate performance is a

hc t ion of differences in this area would be highly useful.( Gerard Caprio, Jr. and

Ross Levine 2002)

To improve corporate governance of financial intermediaries, policy makers

must seek to enhance the ability and incentives of creditors and other market

participants to monitor banks.

Recently, subordinated debt proposals (World Bank, 2001) have received

increased attention. The above arguments apply to nonbank financial intermediaries.

Fortunately, pension h d s and insurance companies are less subject to runs and

generally have been smaller in developing countries. Till now, in emerging markets

they generally have had far less assets under their control than banks, but it is likely

that this will change. Insurance products generally show a high income elasticity of

demand and the lowering of population growth rates and flattening of demographic

pyramids may heighten interest in funded pension systems, so attention to their

better governance is timely. Gathering more and better data on these branches of

finance accordingly should be a priority, for if they follow the experience of high

income countries, their assets will soon dwarf those of banks.

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