Speech by Dr. Louis Kasekende the Deputy Governor of Bank of Uganda at the 5th Annual International Leadership Conference.

 

BANK OF UGANDA

 

 

REMARKS BY DR LOUIS KASEKENDE

DEPUTY GOVERNOR BANK OF UGANDA

AT THE MUBS 

  5TH ANNUAL INTERNATIONAL LEADERSHIP CONFERENCE

KAMPALA SHERATON HOTEL 

26 JUNE, 2014

  

 

   Corporate Governance and the Performance of the Financial Sector

 

  1. Introduction

The function of corporate governance is to ensure that business enterprises are managed in a way which is not destructive to the wider society or to particular groups of their stakeholders. Inherent in the concept of corporate governance is the notion that there are potential conflicts of interest in the management of firms and that those with the power to control the management of firms might take decisions which benefit themselves at the expense of other stakeholders or the general public.

Such conflicts of interest are most acute in large and complex enterprises operating in particular industries such as the extractive industries and the financial services. One way of analysing such conflicts of interest is in terms of market failures, arising from monopoly power, negative externalities or imperfection information. Hence corporate governance can be seen as a tool to try and mitigate market failures. In this lecture I first want to explain why the financial sector is particularly vulnerable to market failures which can give rise to potentially very damaging conflicts of interest, as was vividly demonstrated in the recent global financial crisis. I then want to discuss how we have sought to address these problems in Uganda through efforts to strengthen corporate governance in the banking sector. The role of a bank’s Board of Directors in providing oversight of bank management and ensuring that the bank implements proper risk management policies is at the heart of the approach to corporate governance in banking in Uganda, as it is elsewhere in the world.

  1. What is special about the financial sector which makes corporate governance so important?

Several intrinsic characteristics of the financial sector make it particularly vulnerable to conflicts of interest in which the “insiders”, who are those with the power to control the management of financial institutions, can exploit their power to profit at the expense of other stakeholders, so called “outsiders” who include depositors, non-controlling shareholders and the general public. These intrinsic features of the financial sector are the following.

First, financial assets involve claims on the future. If you hold a share in a company or a deposit in a bank, you have a financial claim which can be realised at some point in the future. The future, however, is inherently uncertain, hence the value of any future claim is also uncertain; it is contingent on events which have yet to happen. This might not be a problem if the same information needed to make informed judgements about the likely future value of financial assets was available to everyone. But this is rarely the case; information is not perfect. Instead there are informational asymmetries. Insiders are often much better informed about the future prospects for financial assets which they control than are outsiders, in large part because the future value of such assets is subject to actions taken by the insiders themselves. As a result, the balance sheets of banks are inherently opaque, especially because a large share of their assets comprise loans whose true value is not directly observable by outsiders. Hence it is very difficult for outsiders to evaluate accurately the true value of a bank’s assets and thus its true financial condition.

Informational asymmetries give incentives for participants in financial markets, such as the insiders, to act in ways which are not in the interest of outsiders and which give rise to market failures. The economics of asymmetric information, with its profound implications for the way in which financial markets work and the market failures to which they are prone, has been one of the most important developments in the discipline of economics in the last 50 years.[1] Joseph Stigliz, George Akerlof and Michael Spence each received the Nobel Prize in economics in 2001 for their pioneering work in this field.

Second, commercial banks and some other types of financial institution (such as hedge funds) are among the most highly geared of all business enterprises. Bank capital as a share of their total liabilities is almost always less than one fifth and usually less than 10 percent (in Uganda, aggregate bank capital is 17 percent of total liabilities). When this very high gearing is combined with the limited liability of shareholders, a feature of commercial law which is common in all modern societies, bank shareholders face an asymmetric alignment of incentives pertaining to the potential gains and losses of risk taking by the bank which they own. In essence, all of the profits of successful risk taking accrue to the shareholders, whereas, with the exception of the very thin layer of capital, the losses of unsuccessful risk taking are borne by the bank’s creditors, who are mainly depositors.

Third, most of the liabilities of banks are owned by a very large number of atomised depositors. These depositors have most to lose from reckless or abusive bank management but because of both a lack of knowledge and “free rider” problems, depositors are not in a strong position to exert any restraining influence over bank management.

Fourth, the potential damage which the failures of large financial institutions – so called systemically important financial institutions – can inflict on the economy is enormous. Economic recessions caused by financial crises are much deeper and last for longer than is typical for recessions. The prolonged recession in many advanced economies of the world following the global financial crisis is an example of this.[2]

Finally, in most market economies including Uganda, the government provides some form of explicit bank deposit insurance. Governments are also widely assumed to provide an implicit guarantee to bail out systemically important financial institutions which are deemed to be too big to fail, because their failure would have disastrous consequences for the economy. These guarantees for bank creditors – explicit and implicit – intensify moral hazard in the financial system, in that they switch the burden of bearing the costs of bank failure from bank creditors to taxpayers, thereby weakening further any restraining influences on reckless or abusive bank management which might be exerted by creditors.

The consequences of these intrinsic features of the financial system are twofold. The first is that management of financial institutions, and especially banks, because they are most highly geared and are covered by deposit insurance, have incentives to engage in much riskier business strategies than is socially optimal. Hence bank failures are more likely to occur, at the cost of their depositors and the taxpayers.

The second consequence is that insiders may have incentives to actually loot their own institutions, through, for example, insider lending, at the expense of non controlling shareholders as well as depositors and the taxpayers. The phenomenon of looting by insiders was examined by George Akerlof and Paul Romer in a seminal article in the Brookings Papers in 1993 which was based on their analysis of the Chilean financial crisis in the 1970s and the 1980s savings and loans crisis and junk bonds scandal, both in the United States.[3]

We can identity three different potential conflicts of interest in financial institutions, all involving the insiders who control the management of the institution and some category of outsiders.

i)                  Between insiders and non controlling shareholders.

ii)               Between insiders and depositors.

iii)            Between insiders and the general public, including the taxpayers.

In essence, corporate governance in financial institutions is intended to ensure that the legitimate interests of all three groups of outsiders – non controlling shareholders, depositors and the general public – are properly taken into account in the management of these institutions.

Before proceeding, it is necessary to say something about the relationship between corporate governance and regulation in the financial sector. The objectives of bank regulation and supervision – to protect depositors and the systemic stability of the financial sector – are very similar to those of corporate governance in the financial sector that I have just discussed. You might thus wonder why we need to bother with corporate governance when we have public regulators, such as the Bank of Uganda, whose responsibility it is to prevent the reckless and abusive management of banks in order to safeguard the interests of deposits and the general public. Might this not be a case of the regulator trying to evade its own responsibility?

My answer to this question is that no financial regulator is omnipotent. Furthermore, the ability of the financial regulator to monitor and influence the behaviour of the management of financial institutions depends heavily on the business environment in which these institutions operate and thus the incentives which their managers face. This was illustrated very clearly by the global financial crisis, the causes of which included major failures of corporate governance.[4] In a business environment in which the imperative for short term profit overrides any other consideration without any proper consideration of the risks involved, and is embraced by almost everyone with any influence within these institutions, including those whose job it is to exercise proper oversight such as Boards of Directors, financial regulators will face a herculean task in trying to restrain reckless risk taking. One of the lessons which I would draw from the global financial crisis is that financial regulation by a public regulator will only be effective if good corporate governance is at least the norm within the financial sector, if not in all financial institutions. I will return to this issue shortly.

  1. Policies for corporate governance in the banking sector in Uganda

Uganda’s approach to the reform of corporate governance in the financial sector has been shaped by the lessons which we drew from several bank failures more than a decade ago and by the evolution of international standards in this area.

In the 1990s and early 2000s, Uganda’s banking industry suffered a number of bank failures. Eight banks failed, forcing the Bank of Uganda (BOU) to intervene and resolve them. In some cases the failed banks were closed, in others they were sold to new owners. The primary cause of most of these bank failures was poor corporate governance. In many of the failed banks, a dominant shareholder or group of shareholders was able to exert undue influence over the management of the bank which resulted in abuses such as pervasive insider lending. The losses incurred on insider loans were the single most important contributor to the collapse of these banks. The Kenyan banking industry was also afflicted by multiple bank failures in the 1990s, with poor corporate governance playing a major role in these failures as it did in Uganda. Poor and abusive management was allowed to flourish in banks because their boards of directors were usually weak, lacking the professional expertise and often the independence and incentives to provide any effective oversight of bank management.

The bank failures of the 1990s prompted the BOU and the Government to strengthen banking regulation. Parliament enacted new legislation in 2004 – the Financial Institutions Act (FIA) – which, inter alia, raised minimum bank capital requirements, tightened restrictions on insider lending and mandated the BOU to intervene promptly in failing banks before their capital is completely eroded and their depositors suffer losses. The FIA also imposes a ceiling of 49 percent on the share of a bank’s equity which a single shareholder, or a group of related shareholders, can hold, in order to limit the influence of dominant shareholders, although this ceiling does not apply to shareholdings by reputable parent banks domiciled in other jurisdictions with good home country bank regulation.

The BOU and the Government also recognised that statutory bank regulation and supervision by a public agency cannot be expected, on its own, to guarantee the sound management of banks, as I have already noted. Moreover, excessively heavy handed regulation, although it might protect depositors, can also stifle innovation and risk taking in banks, which would be detrimental to economic development. In a market economy, the onus for sound management, including the proper management of risks, must lie with the banks themselves. Bank regulators cannot be a substitute for bad bank managers. As such good corporate governance is an essential complement to good bank regulation and supervision.

This principle was made explicit in the Financial Institutions Act, section VII of which is devoted specifically to providing a regulatory framework for good corporate governance in financial institutions. The provisions in section VII of the FIA are supplemented by a set of corporate governance regulations which were issued by the BOU in 2005. Uganda’s corporate governance regulations were influenced by the guidance published by the Basel Committee on Banking Supervision, based at the Bank for International Settlements, which is responsible for formulating global standards for bank regulation and governance.[5]

The corporate governance regulations in Uganda focus on four key themes:

i)                  The fiduciary responsibilities of the Board of Directors;

ii)               The importance of independent oversight of bank management;

iii)            The priority which must be attached to risk management; and

iv)            The need for independent audit functions.

I will elaborate briefly on each of these four themes.

3.1           The Role of the Board of Directors

Uganda’s corporate governance regulations place great emphasis on the fiduciary responsibilities which the Board of Directors owes to the bank, its depositors and shareholders and to the wider society. The Board collectively must take ultimate responsibility for the performance of the bank and for the manner in which it conducts its operations. The directors must lead from the top. They must set the strategic policies of the bank and establish its corporate values. They must also ensure that the bank’s policies prohibit corruption and conflicts of interest in the bank’s operations. An important function of the Board is to define clearly the duties and responsibilities of each member of the bank’s senior management.

To exercise their responsibilities, the directors themselves must be of the highest integrity and have the professional expertise necessary to understand the nature of a banking operation and, in particular, how it differs from that of a non bank company, and what that means for the fiduciary responsibilities of the directors. Uganda’s corporate governance regulations also stress that an individual director cannot hide behind collective board responsibility. Each director can be held individually responsible for any failings of the bank. He or she has a responsibility to report in writing to the bank regulator – the Bank of Uganda – if he or she has any reason to doubt that the bank may not be able to meet all of its obligations to its creditors or may not be able to operate as a going concern in the future.

3.2           Independent oversight of bank management

Uganda’s corporate governance regulations stipulate a clear demarcation of responsibilities between the bank’s Board of Directors and its management. This is a very important principle. The Board must be able to exercise oversight of bank management and hold it to account, which will only be possible if most of the directors are independent of the bank management. This principle is sometimes violated in this country, where the distinction between the respective responsibilities of directors and management is sometimes poorly understood. To ensure that the Board can be independent, Uganda’s corporate governance regulations stipulate that at least half of the directors of a bank, including the Chairperson of the Board, must be non executive directors. The non executive directors should not participate in any way in the day to day running of the bank. In essence, the Board of Directors represent the interests of the bank’s outsiders; its non controlling shareholders, its depositors and the general public. The Board can only properly represent the interest of the outsiders if they are truly independent of the management of the bank.

3.3           Risk management

Bank operations are inherently risky. Banks incur credit risk, liquidity risk, market risk and operational risk. Some degree of risk taking by banks is socially desirable; otherwise there would be virtually no lending to firms and households. However, the amount of risk which a bank incurs must be commensurate with its ability to absorb losses and its managerial capacities for understanding and controlling risk. Therefore, at the core of sound bank management is the proper management of risk. As I have already discussed, bank insiders – the controlling shareholders and management – have incentives to undertake excessive with depositors’ funds. A bank’s risk management policies are intended to control and restrain risk taking so that the nature and degree of its risk exposure does not threaten the solvency of the bank and the safety of its deposits.

Because bank insiders have adverse incentives to engage in excessive risk taking, the Board of Directors, who represent the interests of bank outsiders, must take the lead in formulating effective risk management policies and procedures and in monitoring their implementation by the bank’s management.

The corporate governance regulations require Boards of Directors to establish two Board sub-committees for purposes of risk management; a Risk Management Committee and an Asset Liability Management Committee. The former is responsible for the general oversight of risk management in the bank, while the latter is responsible for setting specific guidelines to manage risk, such as single loan exposure limits and loan to capital ratios. The guidelines set by the Board or its sub committees must, of course, be consistent with the regulations in the FIA where applicable. For example, the Board may approve policies which would raise the bank’s capital above the minimum statutory capital requirements, but it cannot set capital requirements which are lower than the statutory minimum.

3.4           Audit function

Uganda’s banking regulations emphasise the importance of the role played by independent internal and external auditors in ensuring good corporate governance and, in particular, ensuring that the bank’s financial statements accurately and fairly reflect its true financial position. Each bank must have an internal auditor who is independent of the bank management and who reports to the audit committee of the Board. The duties of the internal auditor including evaluating the accuracy of financial information prepared by the bank’s accounting and computer systems and monitoring management’s compliance with the policies and procedures of the bank.

Boards of Directors must use the internal and external auditors as an independent check on the information that is provided by the management of the bank. Because the Board of Directors must approve the audited financial statements of the bank, before they are published, the Directors must have complete confidence in the competence and independence of the auditors who have prepared the financial statements.

  1. Conclusions

Banks perform a unique role in a modern market oriented economy. When banks work well they contribute to economic growth by allocating scarce financial resources efficiently and allowing private companies and individuals to undertake productive investments which they could not fund fully from their own resources. When banks work badly, which is not uncommon, they can inflict damage throughout the economy, causing losses to depositors, firms who need credit and taxpayers. The unique characteristics of banks provide the rationale for prudential regulation by public agencies, such as the Bank of Uganda. But it is unrealistic to expect that bank regulation alone can guarantee the efficient and safe operations of the banking system. Good corporate governance is just as important for sound and efficient bank management as good bank regulation.

Corporate governance must start with the Board of Directors, setting the overall strategic policies of the bank and providing independent oversight of bank management. In particular, the directors must understand clearly their fiduciary responsibilities. They must ensure that the bank’s risk management is adequate to ensure its safe operation, so that depositors funds are protected and that the financial statements provided by the bank to the regulator and the public are accurate.

References

Akerlof, George A. and Paul M. Romer (1993), “Looting: The Economic Underworld of Bankruptcy for Profit”, Brooking Papers on Economic Activity, 2, 1993.

 

Basel Committee on Banking Supervision (2006), “Enhancing corporate governance for banking organisations” Bank for International Settlements, Basel.

 

Freeland, Charles (2009), “Supervisory lessons from market turbulence” in David Mayes, Robert Pringle and Michael Taylor (eds), Towards a new framework for financial stability, Central Banking Publications, London.

 

Reinhart, Carmen and Kenneth S. Rogoff (2014), “Recovery from Financial Crisis: Evidence from 100 Episodes”, American Economic Review Papers and Proceedings, Vol 104, no 5, pp50-55

 

Stiglitz, Joseph E. (2003), Information and the Change in the Paradigm of Economics” in Richard Arnott, Bruce Greenwald, Ravi Kanpur and Barry Nalebuff (eds), Economics for an Imperfect World: Essays in Honor of Joseph E. Stiglitz, MIT Press, Cambridge Massachusetts.

[1] Stiglitz (2003) provides a review of this body of work.

[2] Reinhart and Rogoff, 2014.

[3] Akerlof and Romer, 1993.

[4] Freeland, 2009.

[5] Basel Committee on Banking Supervision (2006). The guidelines on corporate governance were first published by the Basel Committee on Banking Supervision in 1999.

Leave a Reply