T.Y.

BBI
VI SEMESTER

ASSIGNMENT ON:

CORPORATE GOVERNANCE IN
BANKS - AN OVERVIEW
DONE BY:
NICKY PAREKH
ROLL NO : 31
JAIHIND COLLEGE
CORPORATE GOVERNANCE

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“The process and structure..to direct and manage the business and affairs of the
corporation with the objective of enhancing shareholder value, which includes
ensuring the financial viability of the business….”

Corporate governance is the set of processes, customs, policies, laws, and institutions
affecting the way a corporation is directed, administered or controlled. Corporate
governance also includes the relationships among the many stakeholders involved and
the goals for which the corporation is governed. The principal stakeholders are the
shareholders, management, and the board of directors. Other stakeholders include labor
(employees), customers, creditors (e.g., banks, bond holders), suppliers, regulators, and
the community at large.

Corporate governance is a multi-faceted subject. An important theme of corporate

governance is to ensure the accountability of certain individuals in an organization
through mechanisms that try to reduce or eliminate the principal-agent problem.

A related but separate thread of discussions focuses on the impact of a corporate

governance system in economic efficiency, with a strong emphasis shareholders'
welfare. There are yet other aspects to the corporate governance subject, such as the
stakeholder view and the corporate governance models around the world

There has been renewed interest in the corporate governance practices of modern
corporations since 2001, particularly due to the high-profile collapses of a number of
large U.S. firms such as Enron Corporation and MCI Inc. (formerly WorldCom). In
2002, the U.S. federal government passed the Sarbanes-Oxley Act, intending to restore
public confidence in corporate governance.

CORPORATE GOVERNANCE IN BANKS - AN OVERVIEW

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"Sound corporate governance is an important element of bank safety and soundness
and the stability of the financial system. The Basel Committee believes that this will
help to foster more effective risk management and greater transparency on the part
of banking organisations."

Effective corporate governance practices are essential to achieving and maintaining

public trust and confidence in the banking system, which are critical to the proper
functioning of the banking sector and economy as a whole. 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
could in turn trigger a bank run or liquidity crisis. Indeed, in addition to their
responsibilities to shareholders, banks also have a responsibility to their depositors.

The OECD principles define corporate governance as involving “a set of relationships

between a company’s management, its board, its shareholders, and other stakeholders.
Corporate governance also provides the structure through which the objectives of the
company are set, and the means of attaining those objectives and monitoring
performance are determined. Good corporate governance should provide proper
incentives for the board and management to pursue objectives that are in the interests
of the company and its shareholders and should facilitate effective monitoring.

From a banking industry perspective, corporate governance involves the manner in

which the business and affairs of banks are governed by their boards of directors and
senior management, which affects how, they:
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  Set corporate objectives;
 Operate the bank’s business on a day-to-day basis;
 Meet the obligation of accountability to their shareholders and take into account
the interests of other recognized stakeholders;
 Align corporate activities and behavior with the expectation that banks will
operate in a safe and sound manner, and in compliance with applicable laws and
regulations; and
 Protect the interests of depositors.

Supervisors have a keen interest in sound corporate governance as it is an essential

element in the safe and sound functioning of a bank and may affect the bank’s risk
profile if not implemented effectively. As the functions of the board of directors and
senior management with regard to setting policies, implementing policies and
monitoring compliance are key elements in the control functions of a bank, effective
oversight of the business and affairs of a bank by its board and senior management
contributes to the maintenance of an efficient and cost-effective supervisory system.
Sound corporate governance also contributes to the protection of depositors of the
bank and permits the supervisor to place more reliance on the bank’s internal
processes.

Moreover, sound corporate governance practices are especially important in situations

where a bank is experiencing problems, or where significant corrective action is
necessary, as the supervisor may require the board of directors’ substantial
involvement in seeking solutions and overseeing the implementation of corrective
actions. There are unique corporate governance challenges posed where bank
ownership structures either lack transparency or where there are insufficient checks
and balances on inappropriate activities or influences of insiders or controlling
shareholders. The Committee is not suggesting that the existence of controlling
shareholders is in and of itself inappropriate.
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Indeed, controlling shareholders can be beneficial resources for a bank, and in many
markets and for many small banks this is a quite common and appropriate ownership
pattern that does not raise concerns on the part of supervisors. It is nevertheless
important that supervisors take steps to ensure that such ownership structures do not
impede sound corporate governance. In particular, supervisors should have the ability
to assess the fitness and propriety of bank owners.

Good corporate governance requires appropriate and effective legal, regulatory and
institutional foundations. A variety of factors, including the system of business laws
and accounting standards, can affect market integrity and overall economic
performance. Such factors, however, are often outside the scope of banking
supervision. Corporate governance arrangements, as well as legal and regulatory
systems, vary widely between countries. Nevertheless, sound governance can be
achieved regardless of the form used by a banking organisation so long as several
essential functions are in place.

There are four important forms of oversight that should be included in the
organizational structure of any bank in order to ensure 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, compliance and audit functions. In addition, it is important that key
personnel are fit and proper for their jobs.

WHAT IS SPECIAL ABOUT CORPORATE GOVERNANCE OF

BANKS?

 Banks are “special,” different from corporations

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 Opaque, financial information more obscure: hard to assess performance and
riskiness.
 More diverse stakeholders (many depositors and often more diffuse equity
ownership, due to restrictions): makes for less incentive for monitoring.
 Highly leveraged, many short-term claims: risky, easily subject to bank runs.
 Heavily regulated: given systemic importance, as failure can lead to large output
costs, more regulated.
 Because special, banks more regulated, with regulations covering wide area.

 Banks enjoy benefits of public safety net

 Banks, as they are of systemic importance, get support, i.e., deposit insurance,
LOLR, and other (potential) forms of government support.
 Costs of support provided often paid for by government, i.e., in the end taxpayers.
 Implies banks less subject to normal disciplines.

 Same time, banks more subject to CG-risks

 Opaqueness means scope for entrenchment, shifting of risks, private benefits and
outright misuse (tunneling, insider lending, expropriation, etc.) larger than for
non-financial firms.

 As for any firm, bank shareholder value can come from increased risk-taking
 Shareholder value is residual claim on firm value.
 Increased risk-taking raises shareholder values at expenses of debt claimholders
and government.

PRINCIPLES FOR SOUND CORPORATE GOVERNANCE

-BY BASEL COMMITTEE

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‘Enhancing corporate governance for banking organizations is based on eight key
principles:

 Principle 1: Board members should be qualified for their positions, have a clear
understanding of their role in corporate governance and be able to exercise sound
judgment about the affairs of the bank. This includes understanding the bank’s risk
profile and approving the overall risk policy and risk management procedures.

 Principle 2: The board of directors should approve and oversee the bank’s strategic
objectives and corporate values that are communicated throughout the banking
organisation.

 Principle 3: The board of directors should set and enforce clear lines of
responsibility and accountability throughout the organisation.

 Principle 4: The board should ensure that there is appropriate oversight by senior
management consistent with board policy.

 Principle 5: The board and senior management should effectively utilize the work
conducted by the internal audit function, external auditors, and internal control
functions.

 Principle 6: The board should ensure that compensation policies and practices are
consistent with the bank’s corporate culture, long-term objectives and strategy, and
control environment.

 Principle 7: The bank should be governed in a transparent manner.

 Principle 8: The board and senior management should understand the bank’s
operational structure, including where the bank operates in jurisdictions, or through
structures, that impede transparency.
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 THE ROLE OF SUPERVISORS
A bank’s board of directors and senior management are primarily responsible and
accountable for the performance of the bank. Likewise, shareholders should hold the
board accountable for governing the bank effectively. A key role of supervisors is then
to promote strong corporate governance by reviewing and evaluating a bank’s
implementation of the sound principles set forth in section III above. This section
therefore sets forth several principles that can assist supervisors in assessing bank
corporate governance.

Supervisors should provide guidance to banks on sound corporate governance

and the pro-active practices that should be in place.

In developing guidance, supervisors should recognize that banks will need to adopt
different approaches to corporate governance that are proportional to the size,
complexity, structure and risk profile of the bank. The supervisory process should take
this into consideration in evaluating bank corporate governance.

Supervisors should consider corporate governance as one element of depositor

protection.

Sound corporate governance considers not only the interests of shareholders, but also
the interests of depositors. Supervisors should determine that individual banks are
conducting their business in such a way as to not be detrimental to the interests of
depositors. Therefore, depositors’ interests should be considered in conjunction with
any applicable deposit insurance systems, the need to avoid “moral hazard” which may
result from particular approaches to consumer protection, and other relevant principles.

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Supervisors should determine whether the bank has adopted and effectively
implemented sound corporate governance policies and practices.

An important element of supervisory oversight of bank safety and soundness is an

understanding of how corporate governance affects a bank’s risk profile. Supervisors
should not only evaluate corporate governance policies and procedures, but also
evaluate banks’ implementation of these policies and procedures. Supervisors should
expect banks to implement organizational structures that include the appropriate
checks and balances.

Regulatory guidance should emphasize accountability and transparency.

Supervisors, as well as licensing authorities, should obtain necessary information to

evaluate the expertise and integrity of proposed directors and management. The fit and
proper criteria should include, but may not be limited to: (1) the contributions that an
individual’s skills and experience are likely to make to the safe and sound operation of
the bank, and (2) any record of criminal activities or adverse regulatory judgments that
in the supervisor’s judgment make a person unfit to uphold important positions in a
bank.

Supervisors should assess the quality of banks’ audit and control functions.

Supervisors should evaluate whether the bank has in place effective mechanisms
through which the board and senior management execute their oversight
responsibilities. Such mechanisms include internal and external audit, risk
management and compliance functions. In this regard, supervisors should assess the
effectiveness of oversight of these functions by a bank’s board of directors. This could
include (with the consent of senior management, if necessary) meetings with internal
and external auditors as well as senior risk managers, compliance officers, and other
key personnel in control functions. Supervisors should ensure that the internal audit
function conducts independent, comprehensive and effective reviews of bank risk
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management and internal controls. Supervisors should assess the adequacy of internal
controls that foster effective governance. It is important that effective internal controls
not only be well-defined in policies and procedures, but also that they be properly
implemented.

Supervisors should evaluate the effects of the bank’s group structure.

Supervisors should be able to obtain information regarding the structure of the group to
which a bank belongs. For example, management should, upon request by supervisors,
be able to provide a full list of all group entities affiliated with the bank, as well as
business lines of the group. Information about the group structure should allow for an
assessment of the fitness and propriety of the major shareholders and directors of the
parent company and the adequacy of the oversight process within the group, including
coordination of the same functions at the bank and group level. Supervisors should
also ensure that there is appropriate internal reporting and communication from the
bank to the parent board, and vice versa, in respect of all material risk and other issues
that may affect the group (e.g. group-wide “know-your-structure”).

Supervisors should bring to the board of directors’ and management’s attention

problems that they detect through their supervisory efforts.

Poor corporate governance practices can be either a cause or a symptom of larger

problems that merit supervisory attention. Supervisors should be attentive to any
warning signs of deterioration in the management of the bank’s activities. When
supervisors believe that the bank has taken risks that it is unable to fully measure or
control, they should hold the board of directors and senior management accountable
and require that corrective measures be taken in a timely manner.

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 CONCLUSION

Let me conclude with a reiteration that the Reserve Bank is continuously striving to
ensure compliance with international standards and best practices of corporate
governance in banks as relevant to India. RBI is also interacting closely with the
Government and the SEBI in this regard. Increasing regulatory comfort in regard to
standards of governance in banks gives greater confidence to shift from external
regulation to internal systems of controls and risk-management. Each of the directors
of the banks has a role in continually enhancing the standards of governance in banks
through a combination of appropriate knowledge and values.

CASE STUDY AND EXAMPLES

Citibank's Sunset in Japan?

Citibank, the banking services unit of the world's largest financial services group,
Citigroup, had been operating in Japan since 1902, and was considered the country's
most successful private bank. But on September 17th 2004, it was ordered by The
Financial Services Agency (FSA), Japan's financial services market monitoring
authority, to shut down its private banking operations in the country, citing violation of
the country's banking laws. The bank was also banned from participating in
government bond auctions. While the incident highlighted the dubious business
practices followed by Citibank, it also initiated a debate on whether the severe penalty
also meant trouble for other foreign banks too in Japan.

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CORPORATE GOVERNANCE - MODEL CODE OF CONDUCT

Need and objective of the Code

Clause 49 of the Listing Agreement entered into with the Stock Exchanges, requires, as
part of Corporate Governance the listed entities to lay down a Code of Conduct for
Directors on the Board of an entity and its Senior Management. Senior Management
has been defined to include personnel who are members of its Core Management and
functional heads excluding the Board of Directors. Accordingly the Board has laid
down this Code for its Directors on the Board and its Core Management

Bank's belief system

This Code of Conduct attempts to set forth the guiding principles on which the Bank
shall operate and conduct its daily business with its multitudinous stakeholders,
government and regulatory agencies, media and anyone else with whom it is
connected. It recognizes that the Bank is a trustee and custodian public money and in
order to fulfill its fiduciary obligations and responsibilities, it has to maintain and
continue to enjoy the trust and confidence of public at large. The Bank acknowledges
the need to uphold the integrity of every transaction it enters into and believes that
honesty and integrity in its internal conduct would be judged by its external behavior.
The Bank shall be committed in all its actions to the interest of the countries in which
it operates. The Bank is conscious of the reputation it carries amongst its customers
and public at large and shall endeavor to do all it can to sustain and improve upon the
same in its discharge of obligations. The Bank shall continue to initiate policies, which
are customer centric and which promote financial prudence.

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Philosophy of the Code

The Code envisages and expects -

a. Adherence to the highest standards of honest and ethical conduct, including

proper and ethical procedures in dealing with actual or apparent conflicts of
interest between personal and professional relationships.
b. Full, fair, accurate, sensible, timely and meaningful disclosures in the periodic
reports required to be filed by the Bank with government and regulatory
agencies.
c. Compliance with applicable laws, rules and regulations.
d. To address misuse or misapplication of the Bank's assets and resources
e. The highest level of confidentiality and fair dealing within and outside the Bank.

A. General Standards of conduct

The Bank expects all Directors and members of the Core Management to exercise
good judgement to ensure the interests, safety and welfare of customers, employees
and other stakeholders and to maintain a co-operative, efficient, positive, harmonious
and productive work environment and business organisation. The Directors and
members of the Core Management while discharging duties of their office must act
honestly and with due diligence.

They are expected to act with that amount of utmost care and prudence which an
ordinary person is expected to take in his / her own business. These standards need to
be applied while working in the premises of the Bank at off-site locations where the
business is being conducted whether in India or abroad at Bank sponsored business and
social events or at any other place where they act as representatives of the Bank.

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B. Conflict of Interest - Related parties

A "conflict of interest" occurs when personal interest of any member of the Board of
Directors and of the Core Management interferes or appears to interfere in any way
with the interests of the Bank. Every member of the Board of Directors and Core
Management has a responsibility to the Bank its stakeholders and to each other.
Although this duty does not prevent them from engaging in personal transactions and
investments, it does demand that they avoid situations where a conflict of interest
might occur or appear to occur. They are expected to perform their duties in a way that
they do not conflict with the Bank's interest such as-

Employment / Outside employment - The members of the Core management are

expected to devote their total attention to the business interests of the Bank. They are
prohibited from engaging in any activity that interferes with their performance or
responsibilities to the Bank or otherwise is in conflict with or prejudicial to the Bank.

Business interests - If any member of the Board of Directors and Core Management
considers investing in securities issued by the Bank's customer, supplier or competitor,
they should ensure that these investments do not compromise their responsibilities to
the Bank. Many factors including the size and nature of investments; their ability to
influence Bank's decisions; their access to confidential information of the Bank or of
the other entity and the nature of relationship between the Bank and the customer,
supplier or competitor should be considered in determining whether a conflict exists.
Additionally, they should disclose to the Bank any interest that they have which may
conflict with the business of the Bank.

C. Applicable Laws

The Directors of the Bank and Core Management must comply with applicable laws,
regulations, rules and regulatory orders. They should report any inadvertent on-
compliance, if detected subsequently, to the concerned authorities.
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D. Disclosure Standards

The Bank shall make full, fair, accurate, timely and meaningful disclosures in the
periodic reports required to be filed with Government and Regulatory agencies. The
members of the Core management of the Bank shall initiate all actions deemed
necessary for proper dissemination of relevant information to the Board of Directors,
Auditors and other Statutory Agencies, as may be required by applicable laws, rules
and regulations.

E. Use of Bank's Assets and Resources:

Each member of the Board of Directors and Core management has a duty to the Bank
to advance its legitimate interests while dealing with the Bank's assets and resources.
Members of the Board of Directors and Core management are prohibited from: using
corporate property, information or position for personal gain; soliciting, demanding,
accepting or agreeing to accept anything of value from any person while dealing with
the Bank's assets and resources; acting on behalf of the Bank in any transaction in
which they or any of their relative(s) have a significant direct or indirect interest.

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Why care about CG of banks? (I)

• Banks are corporations themselves

• CG affects banks’ valuation and their cost of capital. CG of banks thereby affects the cost of capital of
the firms and households they lend to

• CG affects banks’ performance, i.e., costs of financial intermediation, and thereby the cost of capital
of the firms and households they lend to

• CG affects banks’ risk-taking and risks of financial crises, both for individual banks and for countries’
overall banking systems

• Bank behavior influences economic outcomes

• Banks mobilize and allocate society’s savings. Especially in developing countries, banks can be very
important source of external financing for firms

• Banks exert corporate governance over firms, especially small firms that have no direct access to
financial markets. Banks’ corporate governance gets reflected in corporate governance of firms they
lend to

• Thus, governance of banks crucial for growth, development

What is special about CG of banks?

 Banks are “special,” different from corporations

 Opaque, financial information more obscure: hard to assess performance and riskiness

 More diverse stakeholders (many depositors and often more diffuse equity ownership, due to
restrictions): makes for less incentives for monitoring
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  Highly leveraged, many short-term claims: risky, easily subject to bank runs

 Heavily regulated: given systemic importance, as failure can lead to large output costs, more regulated

 Because special, banks more regulated, with regulations covering wide area

 Activity restrictions (products, branches), prudential requirements (loan classification, reserve reqs.
etc)

 Regulations often more important than laws

 Government, instead of depositors, debt or equity-holders, takes role of monitoring banks

 Power lies with government, e.g., supervisor, deposit insurance agency, central bank

 Raises in turn public governance questions

 Banks enjoy benefits of public safety net

 Banks, as they are of systemic importance, get support, i.e., deposit insurance, LOLR, and other
(potential) forms of government support

 Costs of support provided often paid for by government, i.e., in the end taxpayers

 Implies banks less subject to normal disciplines

 Debt-holders less likely to exert discipline

 Bankruptcy is applied differently or rarer

 Competition is less intense as entry restricted

 Public safety net is large, creating moral hazard

 Same time, banks more subject to CG-risks

 Opaqueness means scope for entrenchment, shifting of risks, private benefits and outright misuse
(tunneling, insider lending, expropriation, etc.) larger than for non-financial firms

 As for any firm, bank shareholder value can come from increased risk-taking

 Shareholder value is residual claim on firm value

 Increased risk-taking raises shareholder values at expenses of debt claimholders and government.

Implications for CG of banks

• Bank ownership
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 • Be very careful on state ownership: negatively related to valuation,
stability and efficiency

• Consider inviting foreign banks

• Bank governance, regulation and supervision

• Strong private owners necessary, but they need to have their own capital
at stake

• Better shareholder protection laws can improve functioning of banks

• Supervision/regulation less effective in monitoring banks.

Reserve Bank’s approach

The formal policy announcement in regard to corporate governance was first

made by my distinguished predecessor, Dr. Bimal Jalan in the Mid-Term Review of the
Monetary and Credit Policy on October 21, 2001. Pursuant to this announcement, a
Consultative Group was constituted in November 2001 under the Chairmanship of Dr.
A.S. Ganguly : basically, with a view to strengthen the internal supervisory role of the
Boards. An Advisory Group on Corporate Governance under the chairmanship of Dr.
R.H. Patil had earlier submitted its report in March 2001 which examined the issues
relating to corporate governance in banks in India including the public sector banks
and made recommendations to bring the governance standards in India on par with
the best international standards. There were also some relevant observations by the
Advisory Group on Banking Supervision under the chairmanship, Shri M.S. Verma
which submitted its report in January 2003. Keeping all these recommendations in
view and the cross-country experience, the Reserve Bank initiated several measures
to strengthen the corporate governance in the Indian banking sector.

In June 2002, the report of the Ganguly Group was transmitted to all the banks for
their consideration while simultaneously transmitting it to the Government of India

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for appropriate consideration. It may be noted here that there is a basic difference
between the private sector banks and public sector banks as far as the Reserve Bank’s
role in governance matters relevant to banking is concerned. The current regulatory
framework ensures, by and large, uniform treatment of private and public sector
banks by the Reserve Bank in so far as prudential aspects are concerned. However,
some of the governance aspects of public sector banks, though they have a bearing
on prudential aspects, are exempt from applicability of the relevant provisions of the
B.R. Act, as they are governed by the respective legislations under which various
public sector banks were set up. In brief, therefore, the approach of RBI has been to
ensure, to the extent possible, uniform treatment of the public sector and the private
sector banks in regard to prudential regulations. In regard to governance aspects
relevant to banking, the Reserve Bank prescribes its policy framework for the private
sector banks while suggesting to the Government the same framework for adoption,
as appropriate, consistent with the legal and policy imperatives.

As a follow-up of the Ganguly Committee report, in Mid-Term Review of the

Monetary and Credit Policy in November 2003, the concept of ‘fit and proper’ criteria
for directors of banks was formally enunciated, and it included the process of
collecting information, exercising due diligence and constitution of a Nomination
Committee of the board to scrutinise the declarations made by the bank directors. In
this regard, it will be useful to refer to the RBI guidelines on ownership and
governance in the private sector banks released recently.

It is heartening to note that based on the guidelines issued by RBI, all the banks in
the private sector have carried out, through their nomination committees, the
exercise of due diligence in respect of the directors on their Boards. In some cases,
where the track record of the directors was not considered satisfactory, the directors
vacated their positions. In regard to some others, there is an on-going process to
ensure ‘fit and proper’ status of the directors.

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 In this regard, it may be useful to distinguish the issue of the composition of the
Board from the ‘fit and proper’ status of individual non-executive directors and chief
executives. The first relates to collective expertise on the Board available to meet the
competitive challenges before the bank to ensure commercial activity while
maintaining soundness. The existing legal provisions in regard to banks stipulate
specific areas of background that a director should be drawn from such as
accountancy, banking, economics, finance, agriculture, etc., but do not specify the
extent or degree of professionalism or expertise required in regard to that area.
Hence, it is left to the good faith of the shareholders to elect directors from the
various specified areas with qualifications and experience that is appropriate to the
bank. In regard to public sector banks, such good faith is expected when directors are
nominated by government.

However, when the issue of ‘fit and proper’ status of non-executive directors
comes up, the norms only seek to ensure that the candidate should not have come to
the adverse notice of the law and regulations or any professional body so that there is
no objection from the RBI. In the case of non-executive directors not satisfying the ‘fit
and proper’ criteria, there is a prescribed due process to be followed by the RBI to
disqualify such directors, which includes opportunities to be heard. The position in
regard to the CEOs of the private sector banks is on a different footing where the
Reserve Bank is in a position to exercise its judgement on the suitability of the
candidates proposed, in as much as the approval of the Reserve Bank is required for
the appointment and the RBI may seek removal also. These provisions are broadly
consistent with global best practices though there is scope for enhancing effective
implementation.

There is no legal provision as of now for the Reserve Bank to insist on the ‘fit and
proper’ status of the directors nominated by the government or elected by the
shareholders to the Boards of the public sector banks. The appointment of the CEOs
in the public sector banks, as well as their removal, is also a matter to be decided only

22
by the Government of India. There is, however, active consultation with the Reserve
Bank in regard to appointment of CEOs. Thus, by and large, there is de facto
compliance with many governance requirements in public sector banks. .

Way forward

As a step towards distancing the regulator from the functioning of the Boards, the
Reserve Bank has withdrawn its nominee directors from almost all the private sector
banks. Observers have been appointed as a transitional measures mostly in respect of
those banks which are yet to fully comply with the Reserve Bank’s guidelines of
ownership of governance. It is hoped that the need for observers also will diminish as
the quality of governance improves.

Second, legislative amendments have been proposed in regard to the public sector
banks to remove the provisions for mandatory nomination of RBI officers on their
boards and thus, to bring them on par with the private sector banks in this regard.

Third, the Government has been requested to keep in view the policy framework
for governance in private sector banks while deciding on the appointments of the
directors on the Boards’ of public sector banks and constitution of various
committees of the Board.

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 Fourth, the RBI, as far as possible, has recently been refraining from issuing
circulars or instructions specifically addressed to the public sector banks. It is
expected that all the existing instructions specifically applicable to the public sector
banks will be reviewed by the Reserve Bank so that uniformity in regulatory
framework between different categories of banks is formally established.

Fifth, several amendments to the Banking Regulation Act have been proposed
which would enhance RBI’s capacity to ensure sound governance specially relevant to
the banks, consistent with global best practices.

In regard to urban co-operative banks (UCBs), there are unique problems which
need to be addressed. Since all the governance aspects of urban co-operative banks
fall entirely within the jurisdiction of the State Governments, while only prudential
aspects are in the RBI’s domain, it has been difficult to ensure effective co-ordination
owing to the problems of dual control in the matters of governance which have a
bearing on prudential regulation. Further, the market discipline in terms of
shareholders’ influence on governance does not exist in regard to urban co-operative
banks since they do not depend on equity markets for their funds. Moreover, the
governance structure in the UCBs seems to be tilted in favour of the borrowers from
the UCBs, thus, possibly undermining the interest of the depositors. Currently, to
avoid problems of dual control, a mechanism of Memorandum of Understanding
(MOU) with the State Governments, is being attempted. RBI has entered into such
MoUs with Andhra Pradesh, Gujarat and Karnataka and is providing facilities for
upgrading the skills of the members of the Board and the management of the UCBs,
in these States

The problem of dual control is even more acute in regard to the rural co-operative
credit structure. However, these are being currently addressed by the Government of
India in the light of the recommendations of the Vaidyanathan Committee.

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 The RRBs are yet another category of banks which are actually owned, in a pre-
determined pattern, by the State, Centre and the sponsor banks. The sponsor banks
are virtually managing the RRBs and the issues of governance of these institutions are
yet to be addressed. Deposit taking NBFCs and, perhaps, NBFCs with systemic
implications may also need to be considered for a careful review of their current
governance practices in view of their unique role and expanding importance in our
financial sector.

Conclusion

Let me conclude with a reiteration that the Reserve Bank is continuously striving
to ensure compliance with international standards and best practices of corporate
governance in banks as relevant to India. RBI is also interacting closely with the
Government and the SEBI in this regard. Increasing regulatory comfort in regard to
standards of governance in banks gives greater confidence to shift from external
regulation to internal systems of controls and risk-management. Each of the directors
of the banks has a role in continually enhancing the standards of governance in banks
through a combination of appropriate knowledge and values.

Guidance on corporate governance for banking organisations published by Basel

Committee

The Basel Committee on Banking Supervision has issued guidance to help promote the
adoption of sound corporate governance practices by banking organisations. This
guidance results from a consultative document published in November 2005, which

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elicited a number of helpful comments from banks, industry associations, supervisory
authorities and other organisations.

The guidance, entitled ‘Enhancing corporate governance for banking organisations’,

builds on a paper originally published by the Committee in 1999, as well as principles
for corporate governance issued by the Organisation for Economic Co-operation and
Development in 2004.

The guidance is intended to help ensure the adoption and implementation of sound
corporate governance practices by banking organisations worldwide, but is not
intended to establish a new regulatory framework.

Mr Jaime Caruana, Chairman of the Basel Committee and Governor of the Bank of
Spain, noted: "Sound corporate governance is an important element of bank safety and
soundness and the stability of the financial system. The Basel Committee believes that
this paper will help to foster more effective risk management and greater transparency
on the part of banking organisations."

‘Enhancing corporate governance for banking organisations’ is based on eight key

principles:

Principle 1: Board members should be qualified for their positions, have a clear
understanding of their role in corporate governance and be able to exercise sound
judgment about the affairs of the bank.

This includes understanding the bank’s risk profile and approving the overall risk
policy and risk management procedures.

Principle 2: The board of directors should approve and oversee the bank’s strategic
objectives and corporate values that are communicated throughout the banking
organisation.
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Principle 3: The board of directors should set and enforce clear lines of responsibility
and accountability throughout the organisation.

Principle 4: The board should ensure that there is appropriate oversight by senior
management consistent with board policy.

Principle 5: The board and senior management should effectively utilise the work
conducted by the internal audit function, external auditors, and internal control
functions.

Principle 6: The board should ensure that compensation policies and practices are
consistent with the bank’s corporate culture, long-term objectives and strategy, and
control environment.

Principle 7: The bank should be governed in a transparent manner.

Principle 8: The board and senior management should understand the bank’s
operational structure, including where the bank operates in jurisdictions, or through
structures, that impede transparency.

http://209.85.175.132/search?
q=cache:H00_QCQUB2EJ:www.ecgi.org/codes/documents/basel_commi
ttee.pdf+corporate+governance+in+banks&hl=en&ct=clnk&cd=8&gl=in

Bank corporate governance

7.The OECD paper defines corporate governance as involving “a set of
relationshipsbetween a company’s management, its board, its
shareholders, and other stakeholders.Corporate governance also provides
the structure through which the objectives of thecompany are set, and the
means of attaining those objectives and monitoring performance
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aredetermined. Good corporate governance should provide proper
incentives for the board andmanagement to pursue objectives that are in
the interests of the company and shareholdersand should facilitate
effective monitoring, thereby encouraging firms to use resources
moreefficiently.”8.Banks are a critical component of any economy. They
provide financing forcommercial enterprises, basic financial services to a
broad segment of the population andaccess to payments systems. In
addition, some banks are expected to make credit and liquidityavailable in
difficult market conditions. The importance of banks to national
economies isunderscored by the fact that banking is virtually universally a
regulated industry and thatbanks have access to government safety nets. It
is of crucial importance therefore that bankshave strong corporate
governance.9.From a banking industry perspective, corporate governance
involves the manner inwhich the business and affairs of individual
institutions are governed by their boards ofdirectors and senior
management, affecting how banks:•set corporate objectives (including
generating economic returns to owners);•run the day-to-day operations of
the business;•consider the interests of recognised stakeholders3;•align
corporate activities and behaviours with the expectation that banks will
operatein a safe and sound manner, and in compliance with applicable
laws and regulations;and•protect the interests of depositors.10.The Basel
Committee has recently issued several papers on specific topics, wherethe
importance of corporate governance is emphasised. These include
Principles for themanagement of interest rate risk (September 1997),
Framework for internal control systemsin banking organisations
(September 1998), Enhancing bank transparency (September 1998),and
Principles for the management of credit risk (issued as a consultative
document in July1999). These papers have highlighted the fact that
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strategies and techniques that are basic tosound corporate governance
include:3“Stakeholders” include employees, customers, suppliers and the
community. Due to the unique role of banks in nationaland local
economies and financial systems, supervisors and governments are also
stakeholders.

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4•the corporate values, codes of conduct and other standards of

appropriate behaviourand the system used to ensure compliance with
them;•a well-articulated corporate strategy against which the success of
the overallenterprise and the contribution of individuals can be
measured;•the clear assignment of responsibilities and decision-making
authorities,incorporating a hierarchy of required approvals from
individuals to the board ofdirectors;•establishment of a mechanism for the
interaction and cooperation among the board ofdirectors, senior
management and the auditors;•strong internal control systems, including
internal and external audit functions, riskmanagement functions
independent of business lines, and other checks and balances;•special
monitoring of risk exposures where conflicts of interest are likely to
beparticularly great, including business relationships with borrowers
affiliated with thebank, 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 tosenior
management, business line management and employees in the form
ofcompensation, promotion and other recognition; and•appropriate
information flows internally and to the public.11.The reality that various

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corporate governance structures exist in different countriesreflects that
there are no universally correct answers to structural issues and that laws
need notbe consistent from country to country. Acknowledging this,
sound governance can bepractised regardless of the form used by a
banking organisation. There are four importantforms of oversight that
should be included in the organisational structure of any bank in orderto
ensure the appropriate checks and balances: (1) oversight by the board of
directors orsupervisory board; (2) oversight by individuals not involved in
the day-to-day running of thevarious business areas; (3) direct line
supervision of different business areas; and (4)independent risk
management and audit functions. In addition, it is important that
keypersonnel are fit and proper for their jobs. Government ownership of a
bank has the potentialto alter the strategies and objectives of the bank as
well as the internal structure ofgovernance. Consequently, the general
principles of sound corporate governance are alsobeneficial to
government-owned banks.

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5III.Sound corporate governance practices12.As mentioned above,

supervisors have a keen interest in determining that banks havesound
corporate governance. The following discussion draws on supervisory
experience withcorporate governance problems at banking organisations
and suggests the types of practicesthat could help to avoid such problems.
These practices should be viewed as critical elementsof any corporate
governance process.Establishing strategic objectives and a set of
corporate values that are communicatedthroughout the banking

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organisation.13.It is difficult to conduct the activities of an organisation
when there are no strategicobjectives or guiding corporate values.
Therefore, the board should establish the strategiesthat will direct the
ongoing activities of the bank. It should also take the lead in
establishingthe “tone at the top” and approving corporate values for itself,
senior management and otheremployees. The values should recognise the
critical importance of having timely and frankdiscussions of problems. In
particular, it is important that the values prohibit corruption andbribery in
corporate activities, both in internal dealings and external
transactions.14.The board of directors should ensure that senior
management implements policiesthat prohibit (or strictly limit) activities
and relationships that diminish the quality ofcorporate governance, such
as:•conflicts of interest;•lending to officers and employees and other
forms of self-dealing (e.g., internallending should be limited to lending
consistent with market terms and to certaintypes of loans, and reports of
insider lending should be provided to the board, and besubject to review
by internal and external auditors); and•providing preferential treatment to
related parties and other favoured entities (e.g.,lending on highly
favourable terms, covering trading losses, waiving
commissions).Processes should be established that allow the board to
monitor compliance with thesepolicies and ensure that deviations are
reported to an appropriate level of management.Setting and enforcing
clear lines of responsibility and accountability throughout
theorganisation.15.Effective boards of directors clearly define the
authorities and key responsibilities forthemselves, as well as senior
management. They also recognise that unspecified lines ofaccountability
or confusing, multiple lines of responsibility may exacerbate a
problemthrough slow or diluted responses. Senior management is
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responsible for creating anaccountability hierarchy for the staff, but must
be cognisant of the fact that they are ultimatelyresponsible to the board for
the performance of the bank.

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6Ensuring that board members are qualified for their positions, have a
clearunderstanding of their role in corporate governance and are not
subject to undueinfluence from management or outside concerns.16.The
board of directors is ultimately responsible for the operations and
financialsoundness of the bank. The board of directors must receive on a
timely basis sufficientinformation to judge the performance of
management. An effective number of board membersshould be capable of
exercising judgement, independent of the views of management,
largeshareholders or governments. Including on the board qualified
directors that are not membersof the bank’s management, or having a
supervisory board or board of auditors separate from amanagement board,
can enhance independence and objectivity. Moreover, such members
canbring new perspectives from other businesses that may improve the
strategic direction givento management, such as insight into local
conditions. Qualified external directors can alsobecome significant
sources of management expertise in times of corporate stress. The boardof
directors should periodically assess its own performance, determine where
weaknessesexist and, where possible, take appropriate corrective
actions.17.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 itsshareholders;•serve as a “checks and balances”

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function vis-à-vis the day-to-day management ofthe bank;•feel
empowered to question management and are comfortable insisting
uponstraightforward explanations from management;•recommend sound
practices gleaned from other situations;•provide dispassionate advice;•are
not overextended;•avoid conflicts of interest in their activities with, and
commitments to, otherorganisations;•meet regularly with senior
management and internal audit to establish and approvepolicies, establish
communication lines and monitor progress toward
corporateobjectives;•absent themselves from decisions when they are
incapable of providing objectiveadvice;•do not participate in day-to-day
management of the bank.18.In a number of countries, bank boards have
found it beneficial to establish certainspecialised committees including:•a
Risk management committee - providing oversight of the senior
management’sactivities in managing credit, market, liquidity, operational,
legal and other risks of

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7the bank. (This role should include receiving from senior management
periodicinformation on risk exposures and risk management activities).•an
Audit committee - providing oversight of the bank’s internal and external
auditors,approving their appointment and dismissal, reviewing and
approving audit scope andfrequency, receiving their reports and ensuring
that management is takingappropriate corrective actions in a timely
manner to address control weaknesses,non-compliance with policies, laws
and regulations, and other problems identified byauditors. The
independence of this committee can be enhanced when it is comprisedof

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external board members that have banking or financial expertise.•a
Compensation committee – providing oversight of remuneration of
seniormanagement and other key personnel and ensuring that
compensation is consistentwith the bank’s culture, objectives, strategy
and control environment.•a Nominations committee – providing important
assessment of board effectivenessand directing the process of renewing
and replacing board members.Ensuring that there is appropriate oversight
by senior management.19.Senior management is a key component of
corporate governance. While the board ofdirectors provides checks and
balances to senior managers, similarly, senior managers shouldassume
that oversight role with respect to line managers in specific business areas
andactivities. Even in very small banks, key management decisions
should be made by more thanone 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 necessaryprerequisite skills or
knowledge;•senior managers who are unwilling to exercise control over
successful, keyemployees (such as traders) for fear of losing
them.20.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 andthe chief auditor. These
individuals must have the necessary skills to manage the businessunder
their supervision as well as have appropriate control over the key
individuals in theseareas.Effectively utilising the work conducted by
internal and external auditors, in recognitionof the important control
function they provide.21.The role of auditors is vital to the corporate
governance process. The effectiveness ofthe board and senior
management can be enhanced by: (1) recognising the importance of
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theaudit process and communicating this importance throughout the bank;
(2) taking measuresthat enhance the independence and stature of auditors;
(3) utilising, in a timely and effectivemanner, the findings of auditors; (4)
ensuring the independence of the head auditor throughhis reporting to the
board or the board's audit committee; (5) engaging external auditors to

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8judge the effectiveness of internal controls; and (6) requiring timely

correction bymanagement of problems identified by auditors.22.The
board should recognise and acknowledge that the internal and external
auditorsare their critically important agents. In particular, the board
should utilise the work of theauditors as an independent check on the
information received from management on theoperations and performance
of the bank.Ensuring that compensation approaches are consistent with
the bank’s ethical values,objectives, strategy and control
environment.23.Failure to link incentive compensations to the business
strategy can cause orencourage managers to book business based upon
volume and/or short-term profitability tothe bank with little regard to
short or long-term risk consequences. This can be seenparticularly with
traders and loan officers, but can also adversely affect the performance
ofother support staff.24.The board of directors should approve the
compensation of members of seniormanagement and other key personnel
and ensure that such compensation is consistent with thebank’s culture,
objectives, strategy and control environment. This will help to ensure
thatsenior managers and other key personnel will be motivated to act in
the best interests of thebank.25.In order to avoid incentives being created

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for excessive risk-taking, the salary scalesshould be set, within the scope
of general business policy, in such a way that they do notoverly depend
on short-term performance, such as short-term trading gains.Conducting
corporate governance in a transparent manner26.As set out in the Basel
Committee’s paper Enhancing bank transparency, it isdifficult to hold the
board of directors and senior management properly accountable for
theiractions and performance when there is a lack of transparency. This
happens in situationswhere the stakeholders, market participants and
general public do not receive sufficientinformation on the structure and
objectives of the bank with which to judge the effectivenessof the board
and senior management in governing the bank.27.Transparency can
reinforce sound corporate governance. Therefore, public disclosureis
desirable in the following areas:•Board structure (size, membership,
qualifications and committees);•Senior management structure
(responsibilities, reporting lines, qualifications andexperience);•Basic
organisational structure (line of business structure, legal entity structure);

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9•Information about the incentive structure of the bank (remuneration

policies,executive compensation, bonuses, stock options);•Nature and
extent of transactions with affiliates and related parties.44For example,
the International Accounting Standards Committee defines related parties
as "those able to control orexercise significant influence. Such
relationships include: (1) parent-subsidiary relationships; (2) entities
under commoncontrol; (3) associates; (4) individuals who, through
ownership, have significant influence over the enterprise and

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closemembers of their families; and (5) key management personnel". The
IASC expects that disclosures in this area shouldinclude. (a) the nature of
relationships where control exists, even if there were no transactions
between the related parties;and (b) the nature and amount of transactions
with related parties, grouped as appropriate. (IASC
InternationalAccounting Standard No. 24, Related Party Disclosures).

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10IV.Ensuring an environment supportive of sound corporate

governance28.The Basel Committee recognises that primary
responsibility for good corporategovernance rests with boards of directors
and senior management of banks; however, thereare many other ways that
corporate governance can be promoted, including by:•governments –
through laws;•securities regulators, stock exchanges – through disclosure
and listing requirements;•auditors – through audit standards on
communications to boards of directors, seniormanagement and
supervisors; and•banking industry associations – through initiatives
related to voluntary industryprinciples and agreement on and publication
of sound practices.For example, corporate governance can be improved
by addressing a number of legal issues,such as the protection of
shareholder rights; the enforceability of contracts, including thosewith
service providers; clarifying governance roles; ensuring that corporations
function in anenvironment that is free from corruption and bribery; and
laws/regulations (and othermeasures) aligning the interests of managers,
employees and shareholders. All of these canhelp promote healthy

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business and legal environments that support sound corporategovernance
and related supervisory initiatives.

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11V.The Role of Supervisors29.Supervisors should be aware of the

importance of corporate governance and itsimpact on corporate
performance. They should expect banks to implement
organisationalstructures that include the appropriate checks and balances.
Regulatory safeguards mustemphasise accountability and transparency.
Supervisors should determine that the boards andsenior management of
individual institutions have in place processes that ensure they
arefulfilling all of their duties and responsibilities.30.A bank’s board of
directors and senior management are ultimately responsible for
theperformance of the bank. As such, supervisors typically check to
ensure that a bank is beingproperly governed and bring to management’s
attention any problems that they detect throughtheir supervisory efforts.
When the bank takes risks that it cannot measure or control,supervisors
must hold the board of directors accountable and require that corrective
measuresbe taken in a timely manner. Supervisors should be attentive to
any warning signs ofdeterioration in the management of the bank’s
activities. They should consider issuingguidance to banks on sound
corporate governance and the pro-active practices that need to bein place.
They should also take account of corporate governance issues in issuing
guidance onother topics.31.Sound corporate governance considers the
interests of all stakeholders, includingdepositors, whose interests may not
always be recognised. Therefore, it is necessary forsupervisors to

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determine that individual banks are conducting their business in such a
way asnot to harm depositors.

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