bank corporate governance
TRANSCRIPT
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Introduction to Banks
The bulk of all money transactions today involve the transfer of
bank deposits. Depository institutions, which we normally callbanks, are at the very center of our monetary system. Thus a
basic knowledge of the banking system is essential to an
understanding of how money works.
Bank Deposits and Reserves
The monetary base is created by the Fed when it buys securities
for its own portfolio. Bank deposits themselves are not base
money, rather they are claims on base money. A bank must hold
reserves of base money in order to meet its depositors' cash
withdrawals and to cover the checks written against their
accounts. Reserves comprise a bank's vault cash and what itholds on deposit at the Fed, known as Fed funds. The Fed
requires banks to maintain reserves of at least 10% of their
demand deposits, averaged over successive 14-day periods.
The Movement of Bank Reserves
When a depositor writes a check against his account, his bank
must surrender that amount in reserves to the payees bank for
the check to clear. Reserves are constantly moving from one
bank to another as checks are written and cleared. At the end of
the day, some banks will be short of reserves and others long.
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Banks redistribute reserves among themselves by trading in the
Fed funds market. Those long on reserves will normally lend to
those short. The annualized interest rate on interbank loans is
known as the Fed funds rate, and varies with supply and demand.
The reserve requirement applies only to the bank's demand
deposits, not its term or savings deposits. Thus when a bank
depositor converts funds in a demand deposit into a term or
savings deposit, he frees up the reserves that were held against
the demand deposit. The bank can then use those reserves in
several ways. For example, it can hold them to back further
lending, buy interest-earning Treasury securities, or lend them toother banks in the Fed funds market.
Controlling the Fed Funds Rate
The supply of reserves changes whenever base money enters or
leaves the banking system. This occurs when the Fed buys or
sells securities or when the public deposits or withdraws cash
from banks. The demand for reserves changes whenever total
demand deposits change, which occurs when banks increase or
decrease aggregate lending. The Fed controls the Fed funds rate
by adjusting the supply of reserves to meet the demand at its
target interest rate. It does so by adding or draining reservesthrough its open market operations.
The Fed funds rate effectively sets the upper limit on the cost of
reserves to banks, and thus determines the interest rates that
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banks must charge the public for loans. Bank interest rates
influence the demand for loans, and thereby the net amount of
bank lending. That in turn determines the liquidity of the private
sector, which is important in terms of aggregate demand and
inflationary pressures. The selection and control of the Fed fundsrate is the key monetary policy instrument of the Fed.
The Effects of Government
SpendingThe Fed acts as a depository for the Treasury as well as member
banks. All government spending is paid out of the Treasury's
account at the Fed. Whenever the government spends, the Fed
debits the Treasury's account and credits the Fed account of the
payees bank. The Treasury replenishes its Fed account with
transfers from its commercial bank accounts where it deposits the
receipts from taxes, and the sale of its securities.
In order to minimize variations in aggregate banking system
reserves, the Treasury maintains a nearly constant balance in its
Fed account. In effect, Treasury payments are simply transfers
from its commercial bank accounts to the bank accounts of the
public. Funds move in the reverse direction when the public pays
taxes or buys securities from the Treasury. The Treasury must
maintain a positive balance in its commercial bank accounts to
avoid having to borrow directly from the Fed. However it has no
need for, and does not accumulate, balances in excess of its near-
term payment obligations.
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On average, government spending does not affect the aggregate
bank deposits of the private sector. The Treasury sells or
redeems securities as required to balance its inflows against
outflows. However short-term variations occur because receipts
cannot be synchronized with spending. Banking system reservesremain essentially unaffected by government spending because
the Treasury transfers funds from its commercial bank accounts
to replace the funds spent out of its Fed account.
History of Banking
Safe in the temple: 18th century BC
Wealth compressed into the convenient form of gold brings one
disadvantage. Unless well hidden or protected, it is easily stolen.
In early civilizations a temple is considered the safest refuge; it is
a solid building, constantly attended, with a sacred character
which itself may deter thieves. In Egypt and Mesopotamia gold is
deposited in temples for safe-keeping. But it lies idle there, while
others in the trading community or in government have desperate
need of it. In Babylon at the time of Hammurabi, in the 18th
century BC, there are records of loans made by the priests of thetemple. The concept of banking has arrived.
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Greek and Roman financiers: from the 4th
century BC
Banking activities in Greece are more varied and sophisticated
than in any previous society. Private entrepreneurs, as well as
temples and public bodies, now undertake financial transactions.
They take deposits, make loans, change money from one
currency to another and test coins for weight and purity.
They even engage in book transactions. Moneylenders can be
found who will accept payment in one Greek city and arrange for
credit in another, avoiding the need for the customer to transport
or transfer large numbers of coins.
Rome, with its genius for administration, adopts and regularizes
the banking practices of Greece. By the 2nd century AD a debtcan officially be discharged by paying the appropriate sum into a
bank, and public notaries are appointed to register such
transactions.
The collapse of trade after the fall of the Roman empire makes
bankers less necessary than before, and their demise is hastened
by the hostility of the Christian church to the charging of interest.
Usury comes to seem morally offensive. One anonymous
medieval author declares vividly that 'a usurer is a bawd to his
own money bags, taking a fee that they may engender together'.
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Functions of a Bank
1. Recognition of Right to Credit
The view thus given of bank credit in general furnishes the key to
the view which should be taken of the bank itself. It is, as we havealready seen, a credit institution - an institution for the
investigation, discussion, and recording of credits. It is not, in this
aspect, what some have described it, an enterprise for
"manufacturing" credit. The "manufacture" of credit, as clearly
appears from what has already been said, is impossible. A basis of
credit is automatically created whenever real buying' power or
value is in process of being brought into existence. Such power is
created during the expenditure of labor and capital, but the realworth or value is often intimately associated with the other
elements that appear in the general operations of his concern.
The basis only appears when it is dissociated from the other
elements in the aggregate of goods and expert means are needed
to recognize it. The first function of a bank, then, is that of
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recognizing through scientific analysis the real nature and amount
of the values which are presented. Fundamentally, therefore, the
credit department of a bank is the basic element in its
organization. It is true that in the past many banks have been
able to do without credit departments and that at the presenttime there are not a few of them - chiefly the smaller and less
advanced types of institution - which have no credit departments,
or only very rudimentary organizations of the sort. These,
however, usually accept the work of credit departments operated
by their city correspondents. The true work of a bank credit
department is done whenever any loan is made. It may be that
the work of credit analysis is incidentally performed by the
president or a vice-president of the bank or by some other officerwho happens to have charge of the work of lending, but the
function is there.
2. Guaranteeing of Values
Secondly, the bank, after recognizing or analyzing credit,
guarantees it. It does this by substituting its own credit for that of
the "borrower" or owner of wealth. If A, for example, is producing
steel from pig iron, the bank ascertains the value of the products
which he has in process, which, we may say, is $25 per ton. It
undertakes to loan, say, $10 per ton, and in order to carry out its
part of the agreement it obligates itself to pay $10 on demand to
anyone who may be designated by the owner of the plant. The
owner leaves with the bank his own note, which may be secured
or may be simply a claim upon his general assets. In either case,
however, the loan is made on the strength of existing value. It
represents that part of the value of the product which the bank iswilling to guarantee. The bank does not expect to be called upon
to meet this obligation for $10 per ton. On the contrary, it expects
to offset the obligation against other claims, and as a net result it
believes that it will not be called upon to reduce its holding of
specie. That, however, is to be determined at a later time. The
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bargain which the bank makes when it enters into relationships
with the borrower involves the substitution of its own obligation
for that of the owner of the goods, and this is the essential point
in the whole operation.
3. Transferring of Titles
Thirdly, the bank not only undertakes to put its obligation in place
of that of the borrower, but it undertakes to keep this obligation
steadily redeemable on demand in money, or in lieu of such
redemption, to shift the "credit" from A to B and from B to any
other that the latter may indicate, through a process ofbookkeeping which involves the receiving, recording, and paying
of claims drawn against the total credit which has been allowed.
Closely connected with this function are the subordinate duties of
exchange and remittance, which, as will be seen at a later point,
are variants of the same general function.
Corporate Governance of Banks
Introduction
The concept of corporate governance, which emerged as a
response to corporate failures and widespread dissatisfaction with
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the way many corporates function, has become one of the wide
and deep discussions across the globe recently. It primarily
hinges on complete transparency, integrity and accountability of
the management. There is also an increasingly greater focus on
investor protection and public interest. Corporate governance isconcerned with the values, vision and visibility. It is about the
value orientation of the organisation, ethical norms for its
performance, the direction of development and social
accomplishment of the organisation and the visibility of its
performance and practices.
Indian Banking Industry
Indian banking has around 200 years of history and has
undergone many transformations since independence. But,
Liberalisation, Privatisation and Globalisation and Information
Technology are currently changing the Indian banking radically.
Earlier, banking was virtually a monopoly of the public sector
banks with full protection from the State. But the process of
reforms in the Indian banking system has thrown them out to
more liberal and free market forces. Now the banks, more
particularly the public sector ones, feel the real heat of the
competition. The interest rate cuts, dwindling margins and more
number of players to serve a reduced number of bankable clientshave all added to the worries of the banks. The customer has
finally come to hold the center stage and all banking products are
tailor-made to suit his tastes and preferences. This sudden
change in the banking environment has bereaved the banks of all
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their comforts and many of them are finding it extremely difficult
to cope with the change.
Need for Corporate Governance in Banks
1. Since banks are important players in the Indian financial
system, special focus on the Corporate Governance in the
banking sector becomes critical.
2. The Reserve Bank of India, as a regulator, has the responsibility
on the nature of Corporate Governance in the banking sector.
3. To the extent that banks have systemic implications, Corporate
Governance in the banks is of critical importance.
4.Given the dominance of public ownership in the banking system
in India, corporate practices in the banking sector would also set
the standards for Corporate Governance in the private sector.
5. With a view to reducing the possible fiscal burden ofrecapitalising the PSBs, attention towards Corporate Governance
in the banking sector assumes added importance.
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Prerequisites for Good Governance
There are some pre-requisites for good corporate governance.They are:
1. A proper system consisting of clearly defined and adequate
structure of roles, authority and responsibility.
2. Vision, principles and norms which indicate development path,normative considerations and guidelines and norms for
performance.
3. A proper system for guiding, monitoring, reporting and control.
Recommendations by the BirlaCommittee
The report of the Committee on Corporate Governance, set up by
the Securities and Exchange board of India, under the
Chairmanship of Kumar Mangalam Birla, is the first formal and
comprehensive attempt to evolve a Code of CorporateGovernance, in the context of prevailing conditions of governance
in Indian companies, as well as the state of capital markets. The
committee has identified the three key constituents of corporate
governance.
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Shareholders' Role
The role of shareholders in corporate governance is to appoint thedirectors and the auditors and to hold the board accountable for
the proper governance of the company by requiring the board to
provide them periodically with the requisite information, in
transparent fashion, of the activities and progress of the
company.
Board of Directors' Role
The board of directors performs the pivotal role in any system of
corporate governance. It is accountable to the stakeholders and
directs and controls the management. It stewards the company,
sets its strategic aim and financial goals, and oversees their
implementation, puts in place adequate internal controls and
periodically reports the activities and progress of the company ina transparent manner to the stakeholders.
Management's Role
The responsibility of the management is to undertake the
management of the company in terms of the direction provided
by the board, to put in place adequate control systems and to
ensure their operation and to provide information to the board on
a timely basis and in a transparent manner to enable the board to
monitor the accountability of management to it.
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The Basel Committee Recommendations
The Basel Committee published a paper for banking organisations
in September 1999. The Committee suggested that it is the
responsibility of the banking supervisors to ensure that there is an
effective corporate governance in the banking industry. It also
highlighted the need for having appropriate accountability and
checks and balances within each bank to ensure sound corporate
governance, which in turn would lead to effective and more
meaningful supervision.
Efforts were taken for several years to remedy the deficiencies of
Basel I norm and Basel committee came out with modified
approach in June 2004. The final version of the Accord titled "
International Convergence of Capital Measurement And Capital
Standards-A- Revised Framework" was released by BIS. This is
popularly known as New Basel Accord of simply Basel ll. Base llseeks to rectify most of the defects of Basel l Accord. The
objectives of Basel ll are the following:
1. To promote adequate capitalisation of banks.
2. To ensure better risk management and
3. To strengthen the stability of banking system.
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Essentials of Accord of Basel ll
1. Capital Adequacy: Basel ll intends to replace the existing
approach by a system that would use external credit assessments
for determining risk weights. It is intended that such an approach
will also apply either directly or indirectly and in varying degrees
to the risk weighting of exposure of banks to corporate and
securities firms. The result will be reduced risk weights for highquality corporate credits and introduction of more than 100% risk
weight for low quality exposures.
2. Risk Based Supervision This ensures that a bank's capital
position is consistent with overall risk profile and strategy thus
encouraging early supervisory intervention. The new framework
lays accent on bank managements developing internal
assessment processes and setting targets for capital that are
commensurate with bank' particular risk profile and control
environment. This internal assessment then would be subjected
to supervisory review and intervention by RBI.
3. Market Disclosures The strategy of market disclosure will
encourage high disclosure standards and enhance the role of
market participants in encouraging banks to hold and maintain
adequate capital.
Steps to be taken
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To overcome from these challenges, banks are required to
emphasize on certain factors, which will increase their
transparency and lead to higher foreign investment.
1. Self- Appraisal System: Good governance is like trusteeship. It
is not just a matter of creating checks and balance but it
emphasizes on customer satisfaction and shareholders value. The
law regulates certain responsible areas on borrowing, lending,
investigating, transparency in accounts etc. The directors, there
fore, evaluate themselves through self-introspection.
2. The Board's Committees: It will be difficult for a board, with all
the members acting together on some issues, to achieve its
objectives effectively and with apt independence. The board,
therefore, needs to be assisted by the some committee.
3. Transparency: Transparency can reinforce sound corporate
governance. Therefore, public disclosure is desirable in BoardStructure, Senior management, Basic organisational structure and
incentive structure of the bank.
Prudential norms on Capital
Adequacy, Income Recognition.
1. Risk Weight on Securities Guaranteed by
State Governments
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In terms of instructions contained in item 4 of paragraph 2 (d) of
our Circular DBOD No BP
BC 103/21.01.002/98 dated October 31, 1998, banks are required
to assign risk weight of 2.5per cent for market risk for their investment in securities where
payment of interest and
repayment of principal are guaranteed by State Governments.
However, in case of default in
interest/principal by the State Government banks are required to
assign 100 per cent risk
weight on investment in all the securities issued or guaranteed by
that State Government.
The position has since been reviewed and it has been decided
that banks need to assign risk
weight of 100 per cent only on those State Government
guaranteed securities issued by
the defaulting entities and not on all the securities issued orguaranteed by that State Government.
Banks are further advised to pay due regard to the record of
particular State Government in
honouring their guarantees while processing any further requests
for loans to PSUs in that
State on the strength of State Government guarantee.
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2. Sick SSI Units under rehabilitationIn terms of paragraph 3 of Circular DBOD No. BP BC
36/21.04.048/95 dated April 3, 1995,
advances granted to units which are placed under rehabilitation
package approved by
BIFR/Term Lending Institutions (TLIs) are treated as NPAs and
provisions are required to
be made. However, for additional credit facilities sanctioned to
units under rehabilitation
package approved by BIFR/TLI, provision need not be made for a
period of one year from
the date of disbursement. In other words, our guidelines on
income recognition, asset
classification and provisioning will apply to such additional credit
facilities only after a
period of one year from the date of disbursement.
Banks have been representing that the above relaxation is not
available in respect of
additional credit facilities granted under the rehabilitationpackage/nursing programme
prepared by banks themselves or under consortium
arrangements. On a review of the matter,
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it has been decided that no provision need be made for a period
of one year in respect of
additional credit facilities granted to SSI units which are identified
as sick (as defined inpara 5 (a) of RPCD Circular No. PFNFS. BC. 99/ 06.02.031/92-93
dated April 17, 1993)
and where rehabilitation packages/nursing programmes have
been drawn by the banks
themselves or under consortium arrangements .
3. Provision on Standard Assets
A reference is invited to para 3 of our Circular DBOD No.
BP.BC.101/ 21.04.048/99 dated
18 October 1999 regarding provision on Standard Assets. In the
light of suggestions received
from banks in regard to treatment and accounting of provision on
Standard Assets, our
instructions are partially modified as under:
The general provision of 0.25 per cent on Standard Assets
should be made on global
portfolio basis and not on domestic advances alone.
Provisions towards Standard Assets need not be netted from
gross advances as
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advised earlier but shown separately as Contingent Provisions
against Standard
Assets, under Other Liabilities and Provisions - Others in
Schedule No. 5 of thebalance sheet.
The above contingent provision will not be eligible for inclusion
in Tier II Capital.
4. Advances against Book Debt
In terms of instructions contained in para 4 of our Circular DBOD
No. BP.
BC.24/21.04.048/99 dated 30 March 1999, banks are required to
show advances against
Book Debt under item B (i)- Secured by tangible assets of
Schedule 9. Although such
advances are secured, it is likely that they may not be fully
secured by tangible assets.
Hence, banks may now indicate separately in Schedule 9 that
item B (i) includes Advances
against Book Debts as shown below:
Advances (Schedule 9)
B (i) Secured by tangible assets *
(* includes advances against Book Debt)
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5. Investment Fluctuation Reserve Account
In terms of instructions contained in paragraph 1 of our circular
DBOD No.
BP.BC.24/21.04.048/99 dated 30 March 1999 the amount held in
Investment Fluctuation
Reserve Account could be utilised to meet, in future, the
depreciation requirement on
investment in securities. In this connection, it is clarified that the
extra provision needed in
the event of a depreciation in the value of the investments should
be debited to the Profit and
Loss Account and if required, an equivalent amount may be
transferred from the Investment
Fluctuation Reserve Account to the Profit and Loss Account as a
below the line item after
determining the profit for the year.
In recent years we have across the term 'prudential norms' too
often particularly in relation to the non-performing assets of the
commercial banks. In the light of the existence of huge non-
performing asset in the balance sheets of the commercial banks
leading to the erosion of their capital base the relevance of these
prudential has acquired particular significance.
The main elements of prudential norms are income recognition,
assets classification , provisioning for loans and advances and
capital adequacy. In keeping with latest practices at the
international levels, commercial banks are not supposed to
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recognize their incomes from non-performing assets on an accrual
basis and these are to be booked only when these are actually
received.
If the balance sheet of a bank is to reflect the factual and true
financial state of affairs of the bank it is pragmatic and desirable
to have a system of recognition of income, classification of assets
and provisioning for sticky debts on a prudential basis. Banks
have been directed not to charge and take interest on non-
performing assets to the income account and classify their assets
under three broad categories of Standard Assets, Sub-standard
Assets, Doubtful Assets and Loss Assets. Taking into account thetime-lag between an account becoming doubtful of recovery, its
recognition as such, the realisation of the security and the erosion
over time in value of security charged to the banks, banks are
required to make provision against sub-standard assets, doubtful
assets and loss assets.
The prudential accounting norms which were put into place in1992-93, have been further strengthened over the years. In
respect of accounts where there are potential threats of recovery
on account of erosion in the value of the security or absence of
security and other factorssuch as fraud committed by the
borrowers exist, such accounts are to be classified as doubtful or
loss assets irrespective of the period to which these remained as
non-performing. All the members banks in a consortium are
required to classify their advances according to each bank's ownrecord of recovery. Depreciation on securities transferred from
the current category to the permanent category has to be
immediately provided for. Banks should value the specified
government securities under ready forward transactions at
market rates on the balance date.
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In recent years we have across the term 'prudential norms' too
often particularly in relation to the non-performing assets of thecommercial banks. In the light of the existence of huge non-
performing asset in the balance sheets of the commercial banks
leading to the erosion of their capital base the relevance of these
prudential has acquired particular significance.
The main elements of prudential norms are income recognition,
assets classification , provisioning for loans and advances andcapital adequacy. In keeping with latest practices at the
international levels, commercial banks are not supposed to
recognize their incomes from non-performing assets on an accrual
basis and these are to be booked only when these are actually
received.
If the balance sheet of a bank is to reflect the factual and truefinancial state of affairs of the bank it is pragmatic and desirable
to have a system of recognition of income, classification of assets
and provisioning for sticky debts on a prudential basis. Banks
have been directed not to charge and take interest on non-
performing assets to the income account and classify their assets
under three broad categories of Standard Assets, Sub-standard
Assets, Doubtful Assets and Loss Assets. Taking into account the
time-lag between an account becoming doubtful of recovery, itsrecognition as such, the realisation of the security and the erosion
over time in value of security charged to the banks, banks are
required to make provision against sub-standard assets, doubtful
assets and loss assets.
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The prudential accounting norms which were put into place in
1992-93, have been further strengthened over the years. In
respect of accounts where there are potential threats of recovery
on account of erosion in the value of the security or absence of
security and other factorssuch as fraud committed by theborrowers exist, such accounts are to be classified as doubtful or
loss assets irrespective of the period to which these remained as
non-performing. All the members banks in a consortium are
required to classify their advances according to each bank's own
record of recovery. Depreciation on securities transferred from
the current category to the permanent category has to be
immediately provided for. Banks should value the specified
government securities under ready forward transactions atmarket rates on the balance date.
Conclusion
Corporate governance has assumed vital role and significance
due to globalisation and liberalisation. With the opening of
economy and to be in line with WTO requirements, if the Indiancorporates have to survive and succeed amidst increasing
competition globally, it can only be through transparency in
operations. The excellence in terms of customer satisfaction, in
terms of return, in terms of product and service, in terms of
return to promoters and in terms of social responsibilities towards
society and people cannot be achieved without practicing good
corporate governance.
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