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Policy Brief on Corporate Governance of Banks in Eurasia

Outline of the Preliminary First Draft

Motoyuki YUFU Principal Administrator, OECD

Tbilisi, Georgia

17 May 2007

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Before we start; The Eurasian Corporate Governance Roundtable

The OECD and the World Bank Group promote five regional roundtables on corporate governance in the world. – The Eurasian Roundtable (Roundtable) was established in 2000.

The Roundtable comprises policy-makers, regulators, academics, stock exchanges, non-governmental institutions and private-sector bodies from 9 Eurasian countries.– Armenia, Azerbaijan, Georgia, Kazakhstan, Kyrgyzstan, Moldova,

Mongolia, Ukraine and Uzbekistan

The Roundtable agreed on a report 　 (2004) “Corporate Governance in Eurasia - A Comparative Overview”

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Before we start; The Task Force on CG of Banks in Eurasia

One of the six priorities of the “Comparative Report”

“Governments should intensify their efforts to improve the regulation and corporate governance of banks.”

The Roundtable decided to launch a task force on bank governance – Experts in banking or capital market– Experts from Eurasia, OECD countries and international

organisations– To develop a policy recommendations/options paper

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Before we start; Some notes for discussion

We would appreciate your understanding on the followings.

– Simultaneous interpreters at work. Please be advised to speak slowly and clearly.

– There are many chapters. Please make sure your comments best suit for the chapter being discussed.

– Any additional comments are welcomed even after the meeting (by email). Motoyuki.yufu@oecd.org

– We would most welcome informal, lively discussion in your private capacities.

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Table of contents of the first draft

Background IntroductionRecommendations section Chapter 1; Boards, board members & committees Chapter 2; Strategic objectives, professional conduct, etc. Chapter 3; Clear lines of responsibilities Chapter 4; Internal controls Chapter 5; Internal/external audit Chapter 6; Compensation Chapter 7; Disclosure Chapter 8; State owned/controlled commercial banks Chapter 9; Banks’ monitoring function on CG Chapter10; Supervisory roles & next steps

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“Background” chapter of the Draft

Introduction to the Roundtable

Task Force; who are we?– Personal views; do not reflect the views of the organisations they serve.

Nature of the Policy Brief– Non-binding – Serves as a source of reference– Not an exhaustive textbook

OECD Principles, SOE Guidelines, Roundtable’s Comparative Report

Harmonisation with the Basel Committee’s work

Would assist wide range of people; – Banks, banking industry associations, institute of directors, stock

exchanges, capital market authorities, and banking supervisors

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“Introduction” chapter of the Draft

Why is bank governance so important? – It is essential to sound & proper banking sector – In Eurasia, banking is the most advanced industry; Banks can be

role models to others in improving corporate governance (CG)

Some definitions– “board” and “senior management” (functional definitions)– “Revision Commissions”

Statutory bodies different from boards Responsibilities in relation to internal audit and supervision Appointed at general shareholder meetings Mostly report directly to general shareholder meetings Named/translated in various ways

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Possible Discussion Points for “Background” & “Introduction”

Paragraph 7 (Why is bank governance so important?)

1) May also refer to the point that;Poor governance can lead to a bank failure which may undermine a core element of market economy, people’s confidence in banks, which was once lost during the period of economic dislocation.

2) May need more stress on depositors, which differentiates bank governance discussion from that of general CG. While minority shareholder protection is a focal point for CG in general, depositors should be highlighted more in the discussion of bank governance.

Paragraph 9 (Definition of boards, etc.)

3) Instead of using “upper/lower boards”, use supervisory board and management board

Paragraph 10 (Definition of “Revision Commissions”)

Let us discuss later (Chapter 5)

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Chapter 1. Boards, board members and committees (1/4)

Chapter 1 deals with four subjects.

1. Importance of boards (paragraph 12)

2. Boards’ independence (paragraph 13-16)

3. Boards’ competence/knowledge and trainings (paragraph 17)

4. Boards’ specialised committees (paragraph 18-20)

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Chapter 1. Boards, board members and committees (2/4)

1. Boards are crucially important

2. Boards’ independence (A) Independence from senior management

• Former employment

• Material business relationship

• Additional remuneration

• Close family ties

• Cross directorship

AND

• Former members of lower boards

(B) Independence from controlling shareholders

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Chapter 1. Boards, board members and committees (3/4)

2. Boards’ independence (Cont.)

How many independent directors? “a sufficient number of independent directors”

How to enforce/implement it?• CG Codes with ‘comply or explain’ basis, but• Laws/regulations with binding force can be another option

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Chapter 1. Boards, board members and committees (4/4)

3. Boards’ competence/knowledge and trainings – Collective knowledge as an entire board– Trainings including CG awareness-raising program

4. Boards’ specialised committees – Boards’ audit committees vs. “Revision Commissions”

– Other committees• They would normally belong to upper boards, not lower boards

• Nomination committees – Not common in Eurasia, but strongly recommended

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Possible Discussion Points for Chapter 1 (1/2)Board, board members & committees

Paragraph 13 &14 (Independent directors)

1) May stipulate more detailed definitions of independent directors.

2) May stipulate positive definition in addition to (OR instead of?) the negative list definition of the draft.

For instance, the ability to exercise objective judgement and provide informed opinion independent of self-interest, management or major shareholders

3) May stipulate that chairperson must be independent.

Paragraph 15 (How many independent directors, etc)

4) May stipulate that the upper limit of the numbers of boards on which one person can concurrently sits is NOT necessarily appropriate.

Paragraph 16 (How to enforce/implement it)

5) Which is better for the requirements of independent directors Hard Law (laws/regulations with binding force), and Soft Law (codes with “comply or explain” basis)

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Possible Discussion Points for Chapter 1 (2/2)Board, board members & committees

Paragraph 17 (Knowledge & training)

6) May stipulate that individual board members (all of them?) must have competence in banking on their appointment, not just general business experiences.

Paragraph 19 (Boards’ audit committees)

7) May stipulate competence of audit committee membersAll members be financially literate and at least one member should posses financial expertise

Paragraph 20 (Boards’ specialised committees)

8) Should they be committees of upper boards or lower boards?

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Chapter 2. Strategic objectives and professional conduct, etc. (1/2)

Cooperation between upper & lower boards in setting objectives, etc.

Implement the objectives, etc.; bank culture – Boards are responsible for nurturing sound bank cultures

Whistleblowers – Employees should be encouraged to communicate their concerns– Procedures (including contact point) should be specified– Protection/confidentiality should be secured

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Chapter 2. Strategic objectives and professional conduct, etc. (2/2)

Related Party Transactions (RPTs)– Core set of regulations exist in many Eurasian countries

• Definition, ban on favourable transactions, lending limits

– How to secure effective observance to them• Make bank boards fully accountable/responsible

Prior approval of materially important RPTs

…But there is a risk of “Rubber Stamping”– Burden of proof (Never approve it unless management

successfully proves it)– Boards’ specialised committees

• Public disclosure

– Outright banning of certain, limited types of RPTs

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Possible Discussion Points for Chapter 2 (1/2) Strategic objectives, professional conduct, etc.

Paragraph 21 (Co-operation in developing strategies, etc.)

1) In Uzbekistan, banking law requires different boards to draft policies according to the nature of policies; some polices (e.g. ALM) to upper boards, and others (e.g. credit) to lower boards.

Paragraph 22 (Nurturing sound bank cultures)

2) May elaborate more on “board members as role models”.

Paragraph 23 (Whistleblowers)

3) May stipulate boards’ obligation to (i) properly address such (bona fide) information and (ii) report back to shareholders on remedies taken.

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Possible Discussion Points for Chapter 2 (2/2) Related party transactions

Paragraph 25 (Boards’ responsibility on RPTs)

4) May refer to regulatory/supervisory measures addressing RPTs stipulated in Basel Core Principle 11.

Principle 11: “In order to prevent abuses arising from exposures to related parties and to address conflicts of interest, supervisors must have in place requirements that;

- banks extend exposures to related parties on an arm’s length basis;

- these exposures are effectively monitored;

- appropriate steps are taken to control or mitigate the risks; and

- write-offs of such exposures are made according to standard policies and processes.”

5) May stipulate (as banks’ internal rules) indemnification requirements on managers who breach relevant rules to get involved in RPTs.

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Chapter 3. Clear lines of responsibilities and accountability

Clear, not multiple, lines– Boards (upper boards) should occupy superior position over

senior management (lower boards)

Upper boards ought to have power in relation to appointment & removal of lower boards– If not, revision of laws recommended– In the meantime, at least, encourage upper boards to

nominate candidates for lower boards

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Possible Discussion Points for Chapter 3 Clear Lines of responsibilities

As a New Paragraph

1) May refer to possible problems arising from dual reporting lines of banks that are subsidiaries of others such as foreign financial institutions.

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Chapter 4 Oversight by senior management and internal control functions

Internal control serves for;1. Performance objectives

2. Information objectives

3. Compliance objectives

Who should do, and what to do? – In varying degrees, everyone’s responsibility in banks – Senior management should establish, monitor and improve it– Boards should ensure that senior management does so

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Possible Discussion Points for Chapter 4 Oversight by senior management & internal control

functions

As a New Paragraph

1) May refer to the “four eyes principle”, values of which are not widely understood.

Four eye’s principle includes; segregation of duties, cross-checking, dual control of assets, double signatures.

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Chapter 5 Internal audit and external auditors (1/3)

“Revision Commissions” Statutory bodies other than boards Responsibilities in relation to internal audit and supervision Appointed at general shareholder meetings, not by boards Mostly report directly to general shareholder meetings

What to do with the “Revision Commissions”?

– (Tentatively) suggests two options

Either empower/activate them, OR replace them

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Chapter 5 Internal audit and external auditors (2/3)

If they are to be empowered/activated;1. Include independent members2. Include full-time members3. Include accounting experts4. Involve in their own nomination process5. Financial resource6. Investigatory power7. Coordination with boards8. Fiduciary duties (legal liability)

Or, replace them– Make it optional for banks to replace them by creating boards’ audit

committees

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Chapter 5 Internal audit and external auditors (3/3)

Banks’ external auditors– Boards and banking supervisors; exchange views with them– legal basis for banking supervisors to hear their views without consent

of banks– Legal obligation to report material breach of laws to banking

supervisors– Legal protection when they report

Availability of external auditors with expertise at a reasonable cost– (No magic formula but..) Get together for nurturing such experts.

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Possible Discussion Points for Chapter 5 (1/2) “Revision Commissions”

Paragraph 32 (Recent reforms in other countries)

1) Any recent fundamental reforms in Eurasia or others in terms of “Revision Commissions”?.

2) “Revision Commissions” in several countries do not have much to do with internal audit functions

Paragraph 33 (Policy options)

3) Should “Revision Commissions” be replaced or empowered?

Should we push the replacement option a little harder?

4) Banks establish boards’ audit committees while maintaining the “Revision Commissions”. Should it be encouraged or discouraged ?

5) Any comments on the draft in terms of the options to empower “Revision Commissions”?

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Possible Discussion Points for Chapter 5 (2/2) Internal audit & external auditors

New Paragraph6) May stipulate internal auditors competency, impartiality and

independence as well as their reporting line.

Paragraph 34 (Relationship with external auditors)

7) May refer to rotation principle and quality assessment.

8) May stipulate legal liability of external auditors for the loss caused by their negligence.

9) May refer to the fact that banking supervision needs competence in accounting standards. Invest more on supervisors’ trainings in relation to this.

10)What are the prerequisites for making it mandatory for external auditors to report material breaches to banking supervisors?

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Chapter 6. Compensation

Extraordinary low remuneration for bank boards (and “Revision Commissions”) is not desirable

Banking supervisors and others may want to provide guidance on compensation

Remuneration for senior management and unitary board’s executive members– Long-term incentive scheme; link to long-term performances of the

bank, not short-term ones

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Possible Discussion Points for Chapter 6 Compensation

Any suggestions?

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Chapter 7. Transparency and disclosure in terms of CG

Ensuring appropriate bank’ public disclosure is important– Market oversight and discipline do work

– Harmonisation to internationally recognised accounting standards

In addition to the items listed on the Basel CG Guidance… Information about “Revision Commissions” should be disclosed, too

Encourage co-operation between banking supervisors & capital market authorities

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Possible Discussion Points for Chapter 7 Transparency and disclosure

Paragraph 39 (Securing appropriate bank disclosure)

1) Should we specifically refer to the harmonisation with IFRS (IASB), not just saying “internationally recognised accounting standards”?

2) May also refer to auditing standards; ISA (IFAC)

3) May also refer to “CEBS Guidelines on Supervisory Disclosure (Committee of European Banking Supervisors)”.

Paragraph 41 (Co-operation between banking & securities regulators)

4) May refer to the experiences of countries who have an integrated financial supervisor. Do we recommend it?

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Chapter 8. Corporate Governance of SOCBs (1/2)

State-Owned/Controlled Commercial Banks (SOCBs) State’s significant control, either full, majority or significant minority

ownership Either direct or indirect ownership Either listed or non-listed Commercial banks

Core concept of the OECD’s SOE Guidelines The state should; – Make SOCBs have professional, effective and independent boards– Utilise the boards to effectively supervise management while

reflecting from day-to-day intervention

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Chapter 8. Corporate Governance of SOCBs (2/2)

The state ownership policy – Prioritised, clear objectives– The state’s role in CG of the SOCB– How to implement the ownership policy

Utilising boards in supervising management– The states should NOT intervene into day-to-day management– Instead, fully utilise/activate SOCB boards;

Professional and independent directors

SOCBs should subject to external auditing– The states’ special audit; not a substitute for an independent

external audit– States should exchange views with external auditors

SOCBs should/can be role models in improving CG

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Possible Discussion Points for Chapter 8 Corporate Governance of SOCBs

Paragraph 42 (CG of banks and SOCBs)

1) May lay emphasis on the fact that challenges of CG of SOCBs are different from that of private-sector banks.

2) May refer to Basel Core Principles para. 14.

To summarise,• Market signals/discipline can be distorted if governments influence

banks’ commercial decisions (e.g. lending) in order to achieve public policy goals.

• In such cases, if guarantees are provided for such lending, they should be disclosed and arrangements be made to compensate the banks when the policy loans cease to perform.

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Chapter 9. Banks’ monitoring of the CG practices of their corporate borrowers

Two different arguments1. Assess and monitor, ex-ante and ex-post, CG standards of

corporate borrowers2. Intervene into CG of corporate borrowers

Assessment and monitoring (ex-ante and ex-post) should be further encouraged– Will benefit banking industry

One of the essential parts of risk management

– Will benefit sustainable national economic growthPolicy tool to improve CG in a country through bank-finance

incentives

Banks’ direct intervention is not encouraged– To prevent banks’ arbitrary decision, criteria on corporate

borrowers’ CG standards should be specified in covenants– Banks themselves ought to improve their CG

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Possible Discussion Points for Chapter 9 Banks’ monitoring of corporate borrowers’ CG

Paragraph 48 (Assessment & monitoring)

1) May refer to the preconditions for effective banking supervision (Basel Core Principles para. 11-13) Preconditions; Effective business law, independent audit based on

accounting principles, auditors are held accountable. “Where shortcomings exist, banking supervisors should make the

government aware of these.”

2) May suggest that banks encourage their large customers to obtain independent credit ratings.

Paragraph 49 (Banks’ intervention)

3) Some expressions may be a bit too restrictive for banks.

4) May also refer to banks’ acquiring holdings in non-financial companies. Clear definition of banks’ permissible businesses Conflicts of interest being managed

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Chapter 10. The role of supervisors and the next steps

Banking supervisors should promote structures in which banks naturally follow sound banking– Effective banking supervision is important, but it is not a panacea.

– More emphasis on promoting good CG of banks

– Monitor whether banks really implement sound CG policies or not

Banking supervisors, in cooperation with capital market authorities and others, should develop a national CG code for banks– Appropriate combination between laws/regulations and voluntary

rules (codes)

– Developing a template based on which banks would develop their own CG codes, respectively

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Possible Discussion Points for Chapter 10 The role of supervisors & next steps

Paragraph 53 (CG codes for banks)

1) Why do we need codes (soft law) in addition to laws & regulations (hard law)? What is an appropriate balance/combination of them?

1) Do we need national CG codes for banks in addition to general CG codes?

Any suggestions for others chapters?

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Thank you very much.