Assessing Corporate Governance in Banks: Lessons Learned from the Review of Banco de Oro

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Assessing Corporate Governance in Banks Lessons
Learned from the Review of Banco de Oro
Stilpon Nestor, Principal
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The Agenda

• Who NeAd and G3
• What Corporate Governance and its Values
• How BDO, a CG revue of an IFC investee bank
• Lessons and conclusions Corporate Governance
  issues in fin. institutions, improving the IFC
  approach, improving the revue process and results

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I. Who NeAd and G3
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I. Nestor Advisors Ltd

• The mission
• Provide the highest quality corporate governance
  advice to corporations and financial institutions
• The approach
• Integrated and inter-disciplinary top-level
  expertise by a multinational team of legal,
  financial and management/organization experts
• Client-specific tailor-made services to match
  client company profile, culture and specific
  needs with best practice and market expectations
• Global unrivalled proximity to and visibility
  with global institutional investors, the opinion
  leaders of market perceptions in corporate
  governance and a unique comparative perspective
  on legal and regulatory systems in different
  countries
• Independent one of the first pure-focus
  governance advisors no conflicts of interest
  with other lines of business

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I. NeAd Clients in 2003-2004

• A CAC-40 automotive manufacturer
• A FTSE 100/NYSE-listed integrated oil company
• A FTSE Eurotop 300/NYSE-listed integrated telecom
  operator
• A FTSE Eurotop 300/NYSE-listed financial
  institution
• An Asian emerging market integrated telecom
  operator
• An Asian emerging market financial institution
• A leading US proxy advisor
• The Presidency of the EU Economic and Financial
  Council of Ministers (ECOFIN)
• An OECD/European stock exchange and one major
  Asian emerging market stock exchange
• The Swiss Economics Ministry (SECO)
• The World Bank

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I. The NeAd Principal
Stilpon Nestor Principal

• Principal of Nestor Advisors Ltd (2002-2003),
  London
• Head of OECD Corporate Governance Department
  (1995-2002), Paris
• Developed OECD Principles of CG, the global
  benchmark
• Assisted large institutions/governments/World
  Bank in adoption/implementation of global
  benchmark
• Worked in major OECD and emerging market
  economies on corporate governance, privatisation
  and corporate restructuring
• Member of various Corporate Governance bodies
• ICGN (biggest global investor forum), member of
  the Standards Committee of the board
• OECD Steering Group on Corporate Governance,
  expert member for the 2003-2004 revision of the
  global benchmark
• EASD/UK APCIMS (association of UK/EU brokers
  dealers) Chairman, Corporate Governance Committee
• Numerous CG publications
• Legal (corporate finance) background and
  education
• Thessaloniki Law School
• Universite Libre de Bruxelles (Brussels)
• Harvard Law School (LL.M 83)
• Paris I

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I. An Alliance that covers the world

• G3 a global alliance of 5 senior international
  CG consultants (of which NeAd is a member)
• US (J. Lukomnik and S. Davis)
• S. Africa (P. Armstrong)
• Lat. America (P. Vasconcellos)
• Europe (S. Nestor)
• Combined experience of more than 75 years in CG
  in transition and developed economies.
• Co-authors of national and global codes and
  co-founders of key institutions,

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II. What Corporate Governance and its Values
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II The subject matter what is CG?

• Board leadership An independent, competent and
  engaged board, capable of exercising its
  strategic and monitoring functions
• Transparency and disclosure The availability of
  material, timely, actionable information to the
  board and investors
• Alignment The alignment of incentives of
  corporate insiders with those of other investors
• Shareholder protection A high level of
  protection against insider abuse to providers of
  outside finance
• CG Commitment Clear focus on establishing a
  maintaining an effective system for all of the
  above

TRUST between boards, investors, management and
stakeholders
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II The Value of GovernanceSome Empirical and
Survey Evidence

• Over 10 years, well-governed companies across a
  wide range of sectors have seen superior
  valuation multiples of more than 8 over their
  badly governed peers. (Metrick, Ishi and Gompers
  2002)
• One standard-deviation improvement in governance
  brings an improvement in valuation multiples that
  ranges from 18 for companies in major OECD
  markets to 33 in major emerging markets.
  (Clapper and Love 2002)
• Companies in the top governance quartile across
  25 markets have 33 ROCE companies in the bottom
  quartile have 15 ROCE. (CLSA 2001)
• Global Institutional Investors managing more than
  1 trillion of assets will pay a premium for well
  governed companies. The premium ranges from 12
  in the UK to over 40 for Indonesia. (McKinsey
  2001)

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II Overall Objectives of a Client Company

• Increase investor trust and achieve lower cost of
  capital
• Increase stakeholder trust (regulators,
  employees)
• Improve performance by better organisation at the
  top
• Limit compliance risk of the bank and legal risk
  of its officers

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III. How BDO, a CG revue of an IFC investee
bank
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III. Review Methodology

• Map current practices and institutional framework
  
• Questionnaire (IFC)
• Review of documents
• Review of local regulatory framework
• Interviews (on site)
• Meetings with policy makers/regulators
• Presentation of initial conclusions to BDO
• Comparison of material them against legal
  obligations, peer and best practice
• Identify the strengths and weaknesses of current
  arrangements and fit with BDOs strategic needs
  and cultural background.
• Validate with G3 partners
• Propose to IFC a tailor- made, balanced and
  prioritized programme for CG improvement in BDO

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III. BDO History and context

• Part of the SM group since 1979
• Universal bank license since 1996
• Lowest NPL level in Philippine banking sector
• Professionalization of management
• but family control remains with chairman TCS
• Floated in PSE in 2001, but tiny free float (8)
• IFC convertible loan of 20 million in 2002
• Bond issue of 170 mil
• Rapid expansion of the bank in 2001-2004 Balance
  sheet /revenue 25, payroll 23
• Generali Pilipinas Life Assurance
• Dao Heng bank
• First E-bank.
• Banco Santander
• Equitable/PCI (under way)
• Board with SM friends, 1 truly independent, one
  outsider (DHB), one IFC observer and open to the
  senior SM group members

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III. Key overall findings What worked yesterday
might not work tomorrow

• A committed, conservative and well-respected
  owner
• has assembled a strong management team
• that is driving a soundly-based but ambitious
  expansion program
• But the board plays little role
• while top-level controls remain informal,
  highly- centralized, with little transparency
• Meanwhile, regulators are raising their
  requirements and markets are more
  governance-conscious
• Most governance-related loss of value occurs as a
  result of rapid expansion (organic or by
  acquisition)

BDO should not become a victim of its own
success
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Addressing Threats Related to BDO Governance

• Overload/bounded rationality

• Increase Decentralization
• vertical
• horizontal

• Increase Formalization
• Com. Charters
• Policies
• Practices/procedures

• Management complexity
• More internal stakeholders
• Lack of intra-group transparency of controls and
  decision making processes

• Market confidence
• More external stakeholders
• Succession issues at group level

Independent pairs of eyes
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IIIa. Key findings Board leadership
Situation
Complication
Recommendation
Benefits

• Lack of board responsibility, impossible
  accountability
• Lack of transparency, no new blood, difficulties
  for team dynamics

• Upgrade Nomination Com into CG and Nom com
• -Composition (Swedish)
• -Power advisory (except formal nominations)
• -Tasks Nominations, CG Code, CG Review, Board
  evaluation criteria, board composition
• 2. Create specific categories for Board observers
  and honorary members in CG manual
• - Gradually implement term limits for
  non-executive members

• Board takes responsibility for own destiny,
• -compliance function streamlined,
• -allows major shareholder to maintain board
  control transparently
• -meeting likely regulatory requirements
• 2. Raise engagement levels, maintain wise
  guidance from old hands and outsiders, meat best
  practice norms

• Compliance responsible for corporate governance/
  no board CG functions
• Honorary chairman, IFC observer, great
  differences in engagement

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IIIa. Key findings Board leadership
Situation
Complication
Recommendation
Benefits

• Double trouble High potential for abuse/ nom
  com cannot shape the board
• Low engagement incentives, threat to
  independence,

• 3. Two track nomination process
• Approval all nominations fulfilling minimum
  formalities
• Recommend nominations that meet specific fit
  criteria
• 4.Develop transparent board remuneration scales
  according to engagement level in committees or
  individual grandfathering positions.

• Raise investor confidence while maintaining board
  quality/ regulatory compliance
• Maintain independent status, meet regulatory
  requirements, incentivise collective board
  engagement

• Nomination com has exclusive right to determine
  director slate
• Remuneration of board is very low but some non
  executive members get paid as consultants

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IIIa. Key findings Board leadership
Situation
Complication
Recommendation
Benefits

• Risk issues in a bank are of strategic importance
  and may entail big conflicts of interest
• Owner is limited by bounded rationality. It is
  impossible to oversee management without a
  structured discussion

• 5. Create risk committee at board level and
  include at least 1 non-exec
• -Develop risk philosophy
• -Set risk appetite and limits
• Oversee/ regularly review all risk management
  processes
• 6. Set board strategy calendar including yearly
  retreat.
• -Build strict confidentiality obligations in
  bylaws
• -Set objectives for CEO accordingly

• Meet best practice and possible compliance
  requirements, avoid conflicts while maintaining
  value of risk committee
• Ensures that strategy is set in a rationally
  optimal way enhances the team dynamics of board

• Risk committee is a management committee
• The board has little say in reflecting on big
  strategic decisions. There is no structured
  strategy debate.

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IIIb. Key findings Quality of information
Situation
Complication
Recommendation
Benefits

• Not fully independent. No board responsibility
  for adequacy of internal controls, independence
  of the audit process and integrity of financial
  information. All issues addressed at management
  (comptroller) or chairman level.

• Upgrade AuC
• Full independence
• Responsibility for key accounting policies
• Review all financial disclosures
• Review of financial internal controls, including
  group
• Reception of compliance reports
• Full responsibility for appointing the ext.
  auditor, approving the audit plan, receiving the
  results.
• Review non-audit work

• Comply with BSP regulations, CG Code, global
  standard practice/ enhance effectiveness of
  controls by alleviating burden from chairman and
  establishing collective responsibility

• Audit committee meets quarterly and is only
  overseeing internal audit and receiving ext.
  audit report.

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IIIb. Key findings Quality of information (cont)
Situation
Complication
Recommendation
Benefits

• Not fully independent. No board responsibility
  for adequacy of internal controls, independence
  of the audit process and integrity of financial
  information. All issues addressed at management
  (comptroller) or chairman level.

• Upgrade AuC
• Review DOSRIEs
• Validate IA appointment discuss plan and yearly
  report
• Review all very large loans of more than 1 bil
  pesos
• Serviced by CS, not IA
• Annual calendar, frequent meetings

• Comply with BSP regulations, CG Code, global
  standard practice/ enhance effectiveness of
  controls by alleviating burden from chairman and
  establishing collective responsibility

• Audit committee meets quarterly and is only
  overseeing internal audit and receiving ext.
  audit report.

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IIIb. Key findings Quality of information
Situation
Complication
Recommendation
Benefits
2. Quality of performance indicators to top
management and the board is limited and allows
for only basic financial indicators 3. Outside
investors cannot fully appraise the financials
and the quality of management/governance
2. BOD should invest in a high quality,
automated, group- wide MIS 3. Upgrade AR with,
interalia - Clear segment information -Fully
diluted earnings -Governance review -Vision and
strategy -Values -Key risks
2. High quality information to top management.
Permits the board to maintain a balanced
scorecard. 3. Realize value of good performance
among investors, attract capital, build trust
with regulators and other stakeholders.
2. Current MIS depends on direct extraction of
data from b-units. 3. Annual Report provides a
short less than complete picture of the bank in
terms of fin and non-fin information
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IIIc/d. Key findings Alignment and shareholder
protection
Situation
Complication
Recommendation
Benefits

• While management stays aligned with controlling
  shareholders its alignment with outside investors
  is minimal.
• 1. This seriously curtails investor rights

• The Chairman should head an ad hoc committee of
  the board for instituting long-term performance
  related pay (3-5 year rolling program) with a
  small but growing segment linked to the stock
  price.
• 1. Consider restoring pre-emptive rights

• Increased performance motivation, Alignment to
  shareholder value without jeopardizing the
  conservative approach of BOD.
• 1. Meet standard practice and lower investor risk

• Management receives no performance related pay
  and has little or no stock ownership
• 1. The Articles of Association preclude
  pre-emptive rights, allegedly to enhance future
  listings

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IIIe. Key findings Commitment to good CG
Situation
Complication
Recommendation
Benefits

• Confusion even among senior BOD staff as to what
  are the tasks and scope of different part s of
  management and committees amplified by constant
  regulatory changes and unclear legal status of
  regulations

• Streamline BOD institutional framework
• Committee (board and principal mgmt) Charters
• New comprehensive CG manual signed by the
  directors. Address conflict and conduct issues
  for directors, independent board advise, director
  information rights
• General authorities document for every top level
  process.

• Facilitates management and board work and
  induction
• -Facilitates compliance
• -Facilitates external and internal communications

• Committees do not have clear mandates while the
  CG manual meets some of the BSP requirements
  without addressing some of the SEC ones. It I
  also unnecessarily repeats legal provisions.
  There is no high level document for the
  description of decision making process and
  authorities in the bank.

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IIIe. Key findings Commitment to good CG
Situation
Complication
Recommendation
Benefits
2. Board leverage within the organization is
weak. Disqualification of Attn Estrella as
independent director. 3. means that compliance
officer is responsible for everything and nothing
and there actually might be less line
responsibility
2. Create a powerful in- house office of
Corporate Secretary, to support the work of the
board and its committees and co-ordinate
management input. 3. Split co-coordinating/
disclosure role from substantive and training
responsibility role limited to -AML -Non-financia
l intl controls -Dotted line to AuC
2. Better functioning of the board, safeguarding
of board independence 3. More effective
compliance function, more line responsibility
2. An independent director is the Corporate
Secretary 3. Compliance as a full line function
and internal audit responsibility for all
internal controls
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III. Proposed BDO Corporate Governance Chart
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II. Lessons and Conclusions
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IV. Corporate governance in the banking sector

• Banks are corporate governance bell- weathers and
  their CG arrangements spill over the whole market
• Regulation is extensive and often intrusive
• Importance of compliance function
• Internal controls
• Fit and proper tests
• Risk is a fundamental part of business strategy
• Basel II and the role of the board in market,
  credit and operational risk
• Risk philosophy, tolerance and appetite in credit
  and market risk
• Proper controls and management of operational
  risks (audit committee)
• Independent Audit function
• Explicit management of conflicts between risk,
  credit and b-unit functions
• Financial conglomerate and group issues

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IV. Board CompositionEU Bank Peer Group
Director Background
Previous industry experience
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IV. Board Composition EU Bank Peer Group
Non-Executive Main Professional Occupation
Current Position
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IV. Corporate governance in the banking sector

• Issues in emerging economies
• Weak regulation fighting adverse selection
  through governance and transparency
• Over-prescriptive regulation and conflicting
  requirements
• Small expert pool independence vs. competence
• Politicized boards priming the nomination
  function of the board
• Directed credit and balancing sheet cleaning
  more centralized governance?
• Banks as parts of FIGs controlling related party
  transactions, NPL controls, leveraging strong
  ownership

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IV. Improving the IFC approach where could G3
help

• Policies and guidelines on nominee directors
  profile, nomination process, rights, duties and
  conflict management
• Model charters and policies for banks and their
  committees based on global best practice
• Board guidelines
• Authorities chart
• Board committee charters
• IA, CCO, CS mandate and duties
• Key management committee charters (ALCO, Credit,
  OpsCom)
• Feedback to home country authorities on
  regulatory and supervision inconsistencies
• Benchmarking approach based on market
  expectations and peer practice

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IV. An example of CG benchmarkingThe NeAd
Dashboard Methodology
PENSION FUNDS
ASSET MANAGERS
Top 500 pension funds 5 366 383 million USD
Top 500 asset managers 35 523 209 million USD
Top 100 65 of the top 500 AUM
Top 300 96 of the top 500 AUM
Top 100 pension funds 3 479 637 million USD
Top 300 asset managers 34 219 014 million USD
No Code 70
Code 30
Code 44
No Code 256
including ISS 872 509 million USD
2 087 323 million USD 60 AUM top 100
1 392 314 million USD 40 AUM top 100
11 880 744 million USD 35 AUM top 300
22 338 270 million USD 65 AUM top 300
SELECTED UNIVERSE
Sources Pensions and Investments Global
Investor Magazine - 2003
Sources Pensions and Investments PI Watson
Wyatt World 500 - 2003
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IV. NeAd Dashboard Template
Mother Template 456 Corporate Governance Points
Information to Investors and the Board
Alignment of incentives
Shareholders Rights and Protection
Independent, Competent Engaged Board
456 Corporate Governance Points
Investor CG concerns mapped against Mother
Template
Information to Investors and the Board
Alignment of Incentives
Shareholders Rights and Protection
Independent, Competent Engaged Board
CG Score Template 82 Corporate Governance
Questions used to benchmark Companies against
Investors expectations
82 Corporate Governance Points
CG SCORE
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IV. Top Global Investors Concerns
Ranked by AUM
AUM (million USD)

• Existence of a remuneration committee
• Existence of an audit committee
• Audit committee independence
• Existence of a nomination/governance committee
• Composition/independence of remuneration
  committee members
• Majority of independent directors on the Board
• Composition/independence of nomination committee
  members
• Director shareholding requirements
• Shareholder right to elect directors
• Split CEO/Chairman
• Board role in succession planning
• Director tenure
• Presence of anti-takeover defenses
• Board role in appointing top executives
• Board evaluation

• 11 789 158
• 10 892 351
• 10 720 620
• 10 695 295
• 10 667 219
• 10 262 882
• 9 961 608
• 8 281 190
• 7 189 886
• 6 561 791
• 6 510 452
• 6 388 848
• 6 368 699
• 6 161 432
• 6 108 413

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IV. EU Banking Peer Group
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IV. Sample Overall Dashboard Ranking with more
complete client disclosure
CG Score
Peer avg.
46,3
31,1
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?V. Sample Nomination/Corporate Governance
Committee
Does the Bank have a nomination/corporate
governance committee?
Nordland Bank 1
No
Peers
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IV. Sample Non executive directors share
ownership
Share ownership size (2003)
No board holds collectively 1 or more of
ordinary shares in issue
The largest holding is for the HSBC board with
0.64 of ordinary shares in issue
but only 0,01 with non executive directors
exclusively
Average value held
Ratio value held / annual remuneration
Peers without UBS HSBC
Euros
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IV. Improving the Review Process

• Review team needs to be more than one
• A two-step process (diagnostic presentation and
  separate presentation of tailor- made
  recommendations) is more effective
• CG Reviews need to be followed by implementation
  audit in a years time
• Client identification needs to be clearer
• Board advise or investor due diligence
• Role of investment officer and CG unit

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