Financial Sector Governance: The Role of the Public and Private Sector

1. Financial Sector Governance:The Role of the Public and Private Sector Michael Pomerleano Financial Sector Development Dept. The World Bank

2. Strengthening Financial Sector Governance in Emerging MarketsOverview by Robert E. Litan, Michael Pomerleano, and V. Sundararajan http://www.worldbank.org/wbi/banking/finsecpolicy/pillars/

3. Why Public Financial Sector Governance? The multiple and possibly conflicting roles of the State as: Regulator of financial institutions; Owner of financial institutions; Market participant; Fiduciary agent; Authority directly intervenes in market operations. Why Private Financial Sector Governance? The ability and effectiveness of capital markets to improve the governance of corporates through private and public legal rules; and equally, the improvements in corporate governance promote development of the capital markets. Good governance of banks is critical for fostering effective corporate governance of enterprises The Public and the Private Roles are Inextricably Linked • Public/Private Nexus • Weak states captured by powerful elite corporates • Public misgovernance, state exerts monopoly powers

4. The Governance Nexus

5. What is Governance? • Institutions and practices by which authority is exercised • Arrangements by which incentives of managers, owners, and other stakeholders are aligned: • Principal - agent • Principal - principal • Principal - stakeholders

6. Public sector governance • Good regulatory governance is effective and sustainable only with good public sector governance • Good public sector governance implies respect of the state for the institutions that govern economic and social interactions among them: • Absence of corruption • Approach to competition policy • Effective legal environment • Effective judicial system • Government ownership • As long as political interference in the regulatory process is not costly for the politicians, regulatory governance can not be effective

7. Why Emphasize Financial Sector Governance? Macro EvidenceValuing Governance: The “Corruption Premium” in Global Capital Flows, Shang-Jin Wei The Cost of Weak Governance: The main conclusions are: (i) corruption affects the volume as well as quality of FDI flows, and (ii) corruption distorts the overall structure of capital inflows, e.g., in favor of portfolio flows and bank lending relative to FDI flows, which makes the host country more vulnerable to financial crises. Cost of corruption has been measured by deterred FDI, which ranges from 37% deterred in China to 74% deterred in Azerbaijan

8. Regulatory governance • Good regulatory governance is important to provide • incentives to the sector in a credible manner • Components of good regulatory governance are: • Agency independence –WITH - accountability • Transparency in actions and decisions • Measures to ensure integrity of agency staff Through FSAPs, and the assessments of compliance with financial sector standards and codes, the IMF and the World Bank try to improve regulatory governance.

9. A clinical approach to each specialized industry in the financial sector • Banks and in particular State Banks…blurred distinction between private and public FS • Asset-Management Companies …blurred distinction between private and public FS • Public Pension Fund Management …blurred distinction between private and public FS • Mutual Funds / Collective Investment Vehicles • Capital markets: Effective measures in capital markets to exert governance over corporates

10. Why does corporate governance in banks warrant special attention? • Banks are funded by depositors & their failure may have systemic impact • Operating in an increasingly competitive, volatile global environment • Facing major strategic crossroads (e.g., new technology, consolidation, globalization, deregulation) • Cases during the Asian financial crisis of boards of directors under-performing

11. Bank Governance: The Basle Guidelines Issued in 1999 • Intended complement The OECD’s Corporate Governance Principles • Focused on the unique issues related to corporate governance of banks and set out the key elements of corporate governance in banks Objectives: • To encourage practices which can strengthen corporate governance under diverse structures -e.g. as regards the relative role of the board of directors & management. Document does not promote a particular governance structure (e.g., Anglo-Saxon vs. German models) • To assist supervisors in promoting the adoption of sound corporate governance practices by banking organizations in their countries

12. The Basle guidelines • 1: Strategic objectives & corporate values should be established • 2: Clear lines of responsibility & accountability should be set & enforced • 3: Board members should be qualified, understand clearly their role & not be subject to undue influence from management or outside concerns • 4: There should be appropriate oversight by senior management • 5: Work conducted by internal & external auditors should be effectively utilized • 6: Compensation approaches should be consistent with the bank’s ethical values, objectives, strategy & control environment • 7: Corporate governance should be conducted in a transparent manner

13. Issues in State Banking Corporate Governance of Banks: Concepts and International Observations (Jerry Caprio and Ross Levine) • The situation. More than 40% of the world’s population live in countries in which most bank assets are held by state-owned banks • What are the implications? Government ownership thwarts competitive forces, limits effectiveness of government supervision; banking market suffers from opacity, need to improve accounting, auditing, credit information • Illustrative solutions • Contestability of markets lessens reliance on family or conglomerate relationships • Incentives matter: legal and bankruptcy frameworks • Select countries solutions: • U.S. has published a book with guidelines for the Board of Directors (The OCC guide for bank directors). Thailand, Oman, and East Africa reported that they have recently released guides. • Education/ training for corporate directors re their obligations by a local institute of corporate directors. Switzerland reported that there is a local institute of corporate directors that offers training. Thailand, Philippines and Fiji advised that they recently established local institutes of directors • HKMA issued a guideline on corporate governance in locally incorporated authorized institutions in May 2000. HKMA recommendation 5 : The board of each bank should establish an audit committee with written terms of reference specifying its authorities and duties; the audit committee should be made up of non-executive directors, the majority of whom should be independent • MAS requires banks to separate financial and non-financial businesses; to change their audit firms every five years

14. Asset-Management CompaniesTHE GOVERNANCE OF ASSET MANAGEMENT COMPANIES: SELECTED OBSERVATIONS (David C. Cooke, Managing Director, Barents Group, KPMG) • The situation. • Following the East Asia crisis, IBRA in Indonesia controlled 70% of financial sector assets in Indonesia. Similarly Danaharta in Malaysia, Kamco in Korea. • Often mission statement has conflicting objectives: restore financial stability, minimize taxpayer losses, etc. • Governance of AMCs impacts pace of problem resolution; responsibilities poorly defined; oversight committees not sufficiently separated from management. • Solutions: Provide for independent and informed oversight committee to articulate policy objectives, review performance. • Areas of Oversight authority typically include approval of: Operating policies, Budget and funding proposals, Operating board members, Outside auditor, May also include approval of significant NPL transactions. • Provide an independent operating board with authority to manage AMC activities • Transparent reporting • Encourage stakeholders participation in corporate governance

15. Public Pension Fund Management and Governance (Governance Issues In Public Pension Fund Management Gregorio Impavido) • The situation. 81% of world labor force covered by partially funded or PAYG public schemes; Pension spending can reach 15% of GDP; Implicit pension debt up to 200% of GDP (Transition economies); Publicly managed pension reserves up to 55% of GDP (Malaysia). • In numerous countries multiple objectives; governance structure is murky, and performance of PPFM is poor • What are the implications? Identify good governance practices and distill into governance guidelines aimed at reducing the political influence risks that are associated with central, public pension fund management. • Solutions: • Only one objective: portfolio investing and maximizing returns for retirees. • Development of a satisfactory set of governance guidelines tailored to public pension funds • Governors independent and fit and proper; Governors' responsibility defined by fiduciary law; accountable for fund performance (e.g.,- Ireland, Canada) • Independent performance evaluations should be conducted by external and independent entities on a regular basis. • Internal controls should be established to avoid conflict of interests.

16. Mutual Funds(Mark St. Giles and Sally Buxton, Cadogan Financial) • The situation. • In the US investment fund assets represent 50% of GDP, whereas in Europe 25%. In the transitional economies funds have been used for privatization. Collective investment schemes can become increasingly important financial institutions in developed countries • Types of CIS governance structures • Corporate style mutual funds are found mostly in the U.S. and a few emerging markets, and dominate in terms of value of assets. Directors have a fiduciary responsibility to look after the interests of investors. • 75% of collective investment schemes by number are held in the trust or the contractual form, and are found mostly in developing countries. • The trust: made by trust deed between a management company and a trustee.The trustee has the fiduciary responsibility • The contractual fund: where investors contract with the management company. Protected by a combination of contract law, regulation and the actions of the depositary, which plays a quasi trustee role.

17. Mutual Funds II • No empirical evidence that any one fund legal structure provides improved fund governance .. but • …. probably • Better governance structure when fund management is separate from oversight with independent corporate directors • Regulation and enforcement are needed • Additional solutions. • Ability to exit a fund creates competitive commercial pressure • Transparency is critical to leveling the playing field, pressure funds to perform • Regulation for fair competition

18. How Effective are Capital Markets in Exerting Governance on CorporatesLessons of Recent Experience with Private and Public, Legal Rules Cally Jordan, The World Bank and Mike Lubrano, IFC • The vision is that Pressures of Capital Markets will Improve Governance of Corporates and Improvements in Corporate Governance will Promote Development of Capital Markets. How? • Legal Families” Matter “…legal families appear to shape legal rules, which in turn influence financial markets” (La Porta, et al) • Changes designed to facilitate better governance are not a "silver bullet" . Solutions are inextricably linked to a constellation of legal practices, institutions, corporate governance structures and market conditions • E.g., Hostile takeovers are a strong disciplinary force in U.S. markets. They rely on a well developed high-yield bond market, that was been a source of funding for acquiring firms. However takeovers are not prevalent in emerging markets. • Importance of private rules for governance. Adopted ex ante by contract, often underpinned by voluntary codes of conduct, or through ex post enforcement through contractual dispute resolution, including arbitration, or through market discipline.

19. Key Messages • The finance sector is sufficiently unique to warrant specialized consideration • The costs of poor private and public sector governance in the finance sector are substantial • Recurring themes in the recommendations offered by the authors : • Information asymmetry and the need for improved transparency are recurring recommendations • Regulatory ‘capture’ and incentives must be dealt with • Lack of independence of policy and operations; difficulties with certain mgt structures, government ownerships; practical obstacles • Inadequate skills and competency critical to boards of directors as well as supporting roles (audit, legal, accounting, etc) • Overview was circulated, Book is available fromThe Brookings Institution Press