Banking on better controls

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

The guidance, entitled Enhancing corporate governance for banking organisations, builds on a paper published by the Committee in 1999, as well as principles for corporate governance issued by the OECD in 2004. It is intended to help ensure the adoption and implementation of sound corporate governance practices by banks worldwide, but is not intended to establish a new regulatory framework layered on top of existing national legislation, regulations or codes.

The paper highlights the importance of:

• The roles of boards of directors and senior management;
• Effective management of conflicts of interest;
• The roles of internal and external auditors, as well as internal control functions;
• Governing in a transparent manner, especially where a bank operates in jurisdictions, or through structures that may impede transparency; and
• The role of supervisors in promoting and assessing sound corporate governance practices.

The guidance lists eight principles of sound corporate governance that banks should use as part of their risk controls frameworks. They are:

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 judgement about the affairs of the bank.
The guidance says that the board of directors is ultimately responsible for the operations and financial soundness of the bank.

Banks should have an adequate number and appropriate composition of directors who are capable of exercising judgement independent of the views of management, political interests or inappropriate outside interests.

Independence and objectivity are vital and can be enhanced by including qualified non-executive directors on the board or by having a supervisory board, or board of auditors separate from a management board.

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.

It is difficult to conduct the activities of an organisation when there are no strategic objectives or guiding corporate values. Therefore, the board should establish the strategic objectives and high standards of professional conduct that will direct the ongoing activities of the bank, taking into account the interests of shareholders and depositors, and should take steps to ensure that these objectives and standards are communicated within the organisation.

Principle 3

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

The Basel guidance says that the board of directors is responsible for overseeing management’s actions and consistency with board policies as part of the checks and balances embodied in sound corporate governance. Senior management, on the other hand, is responsible for delegating duties to the staff and establishing a management structure that promotes accountability, while remaining cognisant of senior management’s obligation to oversee the exercise of such delegated responsibility and its ultimate responsibility to the board for the performance of the bank.

Principle 4

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

Senior managers contribute a major element of a bank’s sound corporate governance by overseeing line managers in specific business areas and activities consistent with policies and procedures set by the bank’s board of directors. One of the key roles of senior management is the establishment, under the guidance of the board of directors, of an effective system of internal controls. Even in very small banks, for example, key management decisions should be made by more than one person. Management situations to be avoided include senior managers who are:

• Inappropriately involved in detailed business line decision-making;
• Assigned an area to manage without the necessary prerequisite skills or knowledge; or
• Unwilling or unable to exercise effective control over the activities of apparent “star” employees. This is especially problematic where managers fail to question employees who generate returns that are out of line with reasonable expectations (for example, where supposedly low-risk, low-margin trading activity generates unexpectedly high returns) for fear of losing either revenue or the employee.

Principle 5

The board and senior management should use the work conducted by the internal audit function, external auditors, and internal control functions.

The board should recognise and acknowledge that independent, competent and qualified auditors, as well as internal control functions (including the compliance and legal functions), are vital to the corporate governance process in order to achieve a number of important objectives.

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.

Timely and accurate public disclosure is desirable on a bank’s public website, in its annual and periodic reports, in reports to supervisors, or by other appropriate forms. Disclosure, says the guidance, should be proportionate to the size, complexity, ownership structure, economic significance and risk profile of the bank, as well as whether the bank is publicly traded or non-listed.

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.