Financial Sector Governance: The Roles of the Private Sector

1. Financial Sector Governance: The Roles of the Private Sector Michael Pomerleano Lead Financial Sector Specialist Financial Sector Operations and Policy Department World Bank

2. Corporate Governance of Financial Intermediaries • Why do financial intermediaries present a special governance problem? • Opaqueness- information asymmetries are more important than in other sectors of the economy • Financial contracts span multiple time periods • Due to the implicit or explicit safety net, the financial sector is more regulated than other sectors…this makes them and their corporate governance different • A vast percentage of the banking system is state owned in developing countries. It leads to multiple roles for the government as regulator, owner, etc and creates conflict of interest . Leads to poor performance.

3. 5. Industry-Level Analysis: Instilling Good Governance This volume brings together expertise from policymakers and practitioners to provide a clinical analysis of governance in the financial sector. Examining banks, capital markets, pension funds, AMCs, and mutual funds, it shares global best practices, and highlights some of the critical challenges that lie ahead. Published by Brookings Press, September 2002.

4. Governance of Banks—Issues in State Banking • More than 40% of the world’s population live in countries in which most bank assets are held by state-owned banks 75%-100% 50%-75% 25%-50% 10%-25% 0-10% No response Source: World Bank survey on Prudential Regulation and Supervision, and other World Bank sources

5. Governance of Banks • Banks warrant special attention for governance • 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) • Under-performance of boards of directors has disastrous implications (e.g. during Asia crisis)

6. SHARE OF GOVERNMENT OWNED BANKS % assets of banking system 0 India Brazil Thailand Mexico Switzerland Australia Singapore Government banks Domestic private banks Foreign banks Source: Central banks of various countries

7. Governance of state banks is not easy…banking system profitability lower where state ownership exists Banking system RoA Extent of government control (% assets) (%) Golden share (1) (1) RoA of top 4 banks, together having ~90% market share Source: Websites of central banks; Annual reports; BCG analysis *Boston Consulting Group, Overview of State Bank Performance, for World Bank and IIB Strategic Forum for Bank CEOs in India, June 2003, Goa, India.

8. Governance of Banks—Issues in State Banking • Implications of state-ownership: • Thwarts competitive forces—less ROE pressure on state banks • Less effective government supervision, benign neglect from state owners • Can create distortions, perception that state-banks safer than others • Potential moral hazard, market distortions from sub-optimal lending • Can create opportunities for political interference • Can lead to market distortions due to captive business • Opaque, need to improve accounting, auditing, credit information • Illustrative solutions: • Contestability of markets lessens reliance on family or conglomerate relationships • Independence key to counteract potential negative impact • Incentives—legal and bankruptcy frameworks • **HKMA guideline on corporate governance, May 2000. 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 from non-financial businesses; to change their audit firms every five years

9. 2. Corporate Governance of Banks

10. Governance of Assets Management Companies • Current situation: • Following the East Asia crisis, IBRA in Indonesia controlled 70% of financial sector assets in Indonesia. Unique role—to restore financial sector health, minimize taxpayer losses. In Malaysia– Danaharta; in Korea—KAMCo. • Challenges: • Governance of AMCs impacts pace of problem resolution • Often mission statement has conflicting objectives, responsibilities poorly defined • Oversight committees not sufficiently separated from management • Some approaches: • Provide for independent and informed oversight committee: policy objectives, review performance • Provide an independent operating board with authority to manage AMC activities • Encourage stakeholders’ participation in corporate governance

11. Governance of Public Pension Funds • Current situation: • 49% of the world labour force covered by mandatory, publicly managed defined-benefit pay-as-you-go systems • Evidence suggests a strong link between governance of public pension funds management and investment performance • Challenge: To reduce stakeholders’ risk: • Failure of the government to meet its retirement incomes promises; • Misuse of contributors’ funds by the government to meet its social policy objectives, or for directed lending (other than its retirement incomes objectives); • loss of funds due to corruption or mismanagement.

12. Governance Checklist: Are the roles of the respective parties clear? Are the terms of appointment and termination of mgrs clear? Adequate fit and proper person protections to prevent deliberate manipulation by govt or board? Is mgt open and transparent about governance structures? Open to periodic review/ constructive criticism? How well does its internal/external governance compare with those imposed by the regulator of private pensions? EXAMPLE: Irish National Reserve Fund Act, 2000: Statutory obligation for govt to pay 1% GNP to Fund each year until at least 2055; East independent National Pensions Reserve Fund Commission to control and manage the Fund, discretion to determine and implement an investment strategy; Appt 7 Commissioners by MoF, w/ statutory requirement for substantive expertise; Appt of National Treasury Management Agency as fund mgr w/specified functions for 10 yrs; Strictly commercial investment mandate--secure optimal return over the long-term subject to prudent risk management; explicitly prohibited from investing in Irish Government securities Appt by Commission of investment managers, also custodians of Fund. * A Framework for Public Pension Fund Management. Jeffrey Carmichael and Roberto Palacios, APRA and World Bank, May 2003. Governance of Public Pension Funds *

13. Governance of Mutual Funds • Current situation: • US open-end mutual funds controlled over $3.5 trillion in assets by end of 1996 • Unique role of boards as fiduciaries, negotiate contracts w/ mgt companies, distributors, service providers, establish level of fees—important determinants of shareholders, returns • Various governance structures lead to differing outcomes • Unit trust fund structure (e.g., in UK), trustee style mutual funds • Corporate style mutual funds (e.g., in US), separates management company from trustees • Some observations: • Ability to exit a fund creates competitive commercial pressure, reinforces good governance • Transparency is critical to leveling the playing field, pressure funds to perform • Regulation for fair competition is important • No evidence that any one fund legal structure provides improved fund governance, BUT probably stronger governance where separated fund management from corporate director of a fund • Evidence that when boards are smaller, greater percentage of independent directors, that fees tend to be lower and returns higher (Tufano, 1997)

14. Governance of Capital Markets * *How Effective are Capital Markets in Exerting Governance on Corporates: Lessons of Recent Experience from Private and Public Legal Rules. Cally Jordan and Michel Lubrano, World Bank, April 2002. • Mechanisms for improving capital markets’ governance: • Listing requirements: • Reflect New Focus on Quality vs. Quantity of Issuers • Unavoidable Conflict with Existing Listed Companies • Requires Consensus on Objectively-Determinable Shortcomings in Law/Practice • Novo Mercado Represents an Approach to the “One-Size-Fits-All” Problem • Codes of best practices • Can be important first step in developing sustainable culture of CG for both public and private companies • Probably requires institutionalization with multi-sector involvement • ‘Voluntary Codes’ • Flexibility, responsiveness • Sensitivity to industry specific concerns-- “fiduciary duties” of directors • In UK, reasonably effective; aversion to written law; tradition of reliance on “convention” or custom • Moral suasion as regulatory technique

15. Governance of Capital Markets * *How Effective are Capital Markets in Exerting Governance on Corporates: Lessons of Recent Experience from Private and Public Legal Rules. Cally Jordan and Michel Lubrano, World Bank, April 2002. • Mechanisms for improving capital markets’ governance (continued): • Shareholder rights, disclosure • Cumulative voting • Enhance minority shareholders’ representation at board level and promote management accountability • Originated as “private” rules (corporate charters/by laws) • Overrides “majority rule” voting for directors • Class action • Requires procedural rules or institutions to support them • Experienced judiciary, active body of litigation professionals • Litigious population • Ratings

16. In conclusion…. The Interaction of Public & Private Sector Governance • Public sector governance is a prerequisite for good corporate 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