The role of good governance, disclosure and transparency in banking stability

1
The role of good governance, disclosure and
transparency in banking stability

• David Carse
• Deputy Chief Executive
• Hong Kong Monetary Authority
• 22 February 2001

2
Introduction

• Two important trends in banking regulation and
  supervision have become evident in recent years
• stress on the key role of the directors and
  senior management in ensuring that banks are
  prudently managed
• the role of disclosure and market discipline in
  promoting the accountability of
  directors/management and in discouraging
  excessive risk-taking
• These trends are the subject of this presentation

3
The role of bad corporate governance in the Asian
crisis

• Weak corporate governance in Asian banks was one
  of the key factors in the Asian crisis
• many banks were controlled by owner-managers and
  the board of directors played little role
• banks were often parts of wider conglomerates and
  were used to fund other parts of the group or the
  owners (connected lending)
• management was not professional and lacked
  self-responsibility
• growth was more important than return on capital
• risk management was poor

4
The situation in Hong Kong

• Corporate governance of Hong Kong banks is
  relatively good by regional standards as has been
  shown by their ability to survive the Asian
  crisis intact
• However, there were some weaknesses in the
  performance of the boards of a few local banks
  during the Asian crisis
• in these cases, the board of directors failed to
  play a proper leadership role
• To address this situation, the HKMA issued a
  guideline on corporate governance in locally
  incorporated authorized institutions in May 2000

5
The role of the HKMA

• Promotion of good corporate governance is part of
  the supervisory responsibilities of the HKMA
• Corporate governance is particularly important
  for banks because of the risks they take on and
  because they safeguard other peoples money
• Directors need to ensure that the risks in banks
  are properly managed, and under the Hong Kong
  Banking Ordinance they have a specific legal
  responsibility to do so
• This does not mean that the directors should
  themselves formulate policies for managing risk,
  but they should certainly approve such policies

6
Contents of the HKMA Guideline

• Major responsibilities of the board
• ensure competent management
• approve objectives, strategies and business plans
• ensure that the banks operations are conducted
  prudently and within the framework of laws and
  board policies
• ensure that the banks affairs are conducted with
  a high degree of integrity
• Legal obligations of directors
• The use of auditors, including internal audit
• Specific requirements

7
Specific Requirements (1)

• The board should ensure that the bank establishes
  policies, procedures and controls to manage the
  various types of risk with which it is faced
• 8 types of risk specified by HKMA (i.e. credit,
  interest rate, market, liquidity, operational,
  reputation, legal and strategic risk)
• board should approve relevant policies to manage
  these risks while senior management should put
  them into effect
• policies should not exist merely for forms sake
  (e.g. to satisfy the regulator), but should
  dictate how the bank is actually run in practice

8
Specific Requirements (2)

• The board should ensure that the bank fully
  understands the provisions of section 83 of the
  Banking Ordinance on connected lending and
  establishes a policy on such lending
• section 83 of the Ordinance limits the unsecured
  advances of banks to connected parties (e.g.
  directors and their relatives)
• board should ensure that the bank fully
  understands its legal obligations and establishes
  a policy on connected lending according to the
  minimum standards specified in the Guideline

9
Specific Requirements (3)

• The board should ensure that it receives the
  management letter from the external auditor
  without undue delay, together with the comments
  of management
• management letter should normally be received
  within 4 months from the financial year-end
• board and/or audit committee should ensure
  appropriate action is taken to address any
  weaknesses identified in the management letter
• copy of the management letter should be given to
  the HKMA

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Specific Requirements (4)

• The board should maintain appropriate checks and
  balances against the influence of management
  and/or shareholder controllers, in order to
  ensure that decisions are taken with the banks
  best interests in mind.
• board should have at least 3 independent
  non-executive directors to provide the necessary
  checks and balances and bring in outside
  experience
• banks should notify the names of their
  independent directors to the HKMA
• HKMA may require additional independent directors
  to be appointed

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Specific Requirements (5)

• The board should establish an audit committee
  with written terms of reference specifying its
  authorities and duties
• audit committee should be made up of
  non-executive directors, the majority of whom
  should be independent
• Board meetings of a bank should be held
  preferably on a monthly basis but in any event no
  less than once every quarter
• banks should keep full minutes of board meetings
• HKMA will require banks to provide it with a
  record of the number of board meetings held each
  year

12
Specific Requirements (6)

• Individual directors should attend at least half
  of board meetings held in each financial year
  and all meetings where major issues are to be
  discussed
• participation of directors in board meetings can
  be facilitated by video or telephone conferencing
• HKMA will monitor the attendance records of
  individual directors
• The HKMA will meet the full board of directors of
  each bank every year.
• HKMAs intention is not to participate in board
  meetings but to strengthen communication between
  the HKMA and the banks at the highest level

13
How can good corporate governance of banks be
achieved?

• Main responsibility rests with shareholders,
  directors and management
• Regulation and supervision also play a role
• Both of the above need to be supplemented by
  adequate public disclosure
• This facilitates private sector oversight of the
  risk-taking and financial condition of banks
• disclosure makes directors and senior managers
  more accountable to the various stakeholders
• increases the number of watchful eyes, thus
  reinforcing supervisory efforts

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What should banks disclose? (1)

• Financial performance (breakdown of income and
  expense etc)
• Financial position (breakdown of on and
  off-balance sheet items, including capital
  position and liquid assets)
• Risk management strategies and practices
• Risk exposures (including quantitative and
  qualitative information on credit, market,
  liquidity, operational, legal and other risks)

15
What should banks disclose? (2)

• Accounting policies
• Basic business, management and corporate
  governance information (including business
  strategies, group structure, board and management
  structure, remuneration policies etc)

16
Disclosure and transparency

• Disclosure doesnt necessarily achieve
  transparency
• To achieve transparency, disclosure must enable
  users to properly assess the banks risk profile,
  financial condition and performance, business
  activities etc
• Therefore disclosure must be
• comprehensive
• relevant and timely
• reliable
• comparable
• material

17
The benefits of disclosure (1)

• Well managed banks should benefit, e.g. from
  improved access to capital markets and more
  secure funding at a lower cost
• Enable a more efficient allocation of capital
  between banks by helping shareholders to more
  accurately assess and compare the risk and return
  prospects of individual banks
• Enable a wider set of shareholders to participate
  effectively in the governance of the banks and
  make the corporate governance process more
  transparent

18
The benefits of disclosure (2)

• Enable depositors and other creditors to better
  decide which banks they should place their money
  with and to curb excessive risk-taking
• Reduced risk of market disruptions - ongoing
  disclosure should make market participants less
  likely to overreact to negative information
• Strengthened incentives for banks to behave in a
  prudent and efficient manner

19
The benefits of disclosure (3)

• Reduction in systemic risk through better ability
  to distinguish higher risk banks from those that
  are fundamentally safe and sound
• should reduce the risk of contagion
• Reinforce supervisory guidance by making banks
  disclose when they are non-compliant
• Reduce moral hazard faced by supervisors

20
How can disclosure be made effective?

• Two broad goals in designing effective disclosure
  standards
• how to achieve transparency
• how to achieve market discipline

21
The problems of achieving transparency

• The financial strength and riskiness of banks are
  inherently difficult to evaluate
• problem of how to value loan portfolios
• how to communicate meaningfully the risk appetite
  and quality of risk management of a bank
• difficulty of comparability of financial
  information o/a differences in accounting
  standards, supervisory guidelines,
  interpretation, enforcement
• limits on disclosure of customer information and
  proprietary information, e.g. on risk management
  techniques and strategies
• problem of keeping up to date with rapid changes
  in banks risk profiles

22
The problems of achieving market discipline

• Market participants may not respond to
  information in a way that promotes financial
  stability
• publicly disclosed information may not be
  regarded as sufficiently credible
• participants may rely on official safety nets for
  protection
• retail depositors may be unable to monitor a
  banks condition via public disclosure
• shareholders may fail to discipline management
• management may lack incentives to behave prudently

23
Necessary conditions for disclosure to be
effective

• Effective disclosure depends on the
  infrastructure within which banks operate
• the nature and adequacy of corporate law
• the adequacy of accounting standards and auditing
  requirements
• the expertise and integrity of the auditing
  profession
• the adequacy of the financial news media and
  market commentators and analysts

24
Potential drawbacks of public disclosure

• Cost of producing and providing information
• Market may react more harshly than desirable when
  it becomes aware that a bank is weakened
• potential that bank may fail from liquidity
  problems even if it is solvent
• other banks may be affected through contagion,
  particularly in times of financial stress
• However,contagion risk should be reduced in an
  environment of adequate ongoing public disclosure
• Also, the market incentives provided by
  disclosure should help to correct bank-level
  problems at an early stage

25
The role of supervisors in improving transparency
(1)

• Supervisors should try to promote comparability,
  relevance, reliability and timeliness of
  information disclosed
• issue disclosure standards and guidelines or at
  least influence the debate on these
• Encourage the use of supervisory definitions and
  reporting classifications for public disclosure
  purposes to facilitate comparison of data
• Mediate if banks fail to agree privately on
  standards in order to speed up the process of
  disclosure convergence

26
The role of supervisors in improving transparency
(2)

• Publication of aggregate information received
  from banks
• Difficult to go beyond this to disclose
  information on individual banks, e.g. supervisory
  ratings
• would conflict with the supervisors role to
  maintain banking stability and make it more
  difficult to resolve individual banks problems
• could make supervisors more reluctant to make
  independent judgments about banks if these were
  to be made public
• could make it more difficult to obtain
  confidential information from banks

27
The role of supervisors in improving transparency
(3)

• Supervisors can help to ensure compliance with
  disclosure standards through
• regular review of what banks disclose
• taking action against banks that provide
  insufficient or misleading disclosure
• ensuring that banks have effective accounting
  standards and practices
• maintaining close liaison with internal and
  external auditors

28
The Hong Kong experience of bank disclosure (1)

• Prior to 1992, banks in HK maintained inner
  reserves and disclosed little balance sheet or
  P/L information, e.g.
• one line P/L account net profit after tax and
  transfers to inner reserves
• Rationale was to smooth out large fluctuations in
  profits and thereby help maintain public
  confidence in the banking system
• This was a vital issue in the run-up to the
  Handover in 1997

29
The Hong Kong experience of bank disclosure (2)

• While the stability objective was valid, pressure
  for change became irresistible
• HSBC disclosed inner reserves in 1992 accounts
  following merger with Midland Bank
• lack of disclosure seen as incompatible with HKs
  position as an international financial centre
• criticism from rating agencies and analysts
• SFC/SEHK concern about listed banks
• HKMA persuaded other local banks to disclose
  transfers to inner reserves in 1994 accounts and
  accumulated amount of inner reserves in 1995
  accounts

30
The Hong Kong experience of bank disclosure (3)

• The market reaction to the disclosure of inner
  reserves was uneventful
• Amount of disclosure (e.g. of non-performing
  loans) has been increased each year through
  annual HKMA Guidelines
• Experience has been positive and stabilising
• image of HK banks has improved
• public and media seem to accept that bank profits
  will fluctuate
• announcement of losses by a few banks during the
  Asian crisis was absorbed without incident

31
The Hong Kong experience of bank disclosure (4)

• Disclosure by banks in HK has been rated the best
  in the Region (e.g. by the IMF)
• But banks here cannot afford to relax
• other countries in the Region are catching up and
  even moving ahead in some respects (e.g. Thai
  banks now publish NPLs on a monthly basis)
• the international standards for disclosure are
  being raised all the time
• The New Capital Accord just announced by the
  Basel Committee on Banking Supervision is a prime
  example of this

32
The New Basel Capital Accord

• Will replace the present 1988 Accord in 2004
• More risk-sensitive framework for calculating
  capital requirements
• More emphasis on banks internal methodologies
• More options for banks
• Disclosure and market discipline play a central
  role

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Structure of the New Accord

• Three pillars
• First Pillar - minimum capital requirement
• Second Pillar - supervisory review process
• Third Pillar - market discipline
• All three pillars are intended to be mutually
  reinforcing

34
The Third Pillar

• This aims to bolster market discipline by
  ensuring that market participants can better
  understand banks risk positions and the adequacy
  of their capital
• disclosure mainly directed at wholesale
  counterparties
• The greater use of internal methodologies for
  calculating capital requirements has increased
  the need for disclosure
• ensure that these are exposed to public scrutiny
• knowledge of methodologies used by different
  institutions will make comparability easier

35
Disclosure policy statement

• Disclosure should be embedded in the management
  process and given sufficient status
• Banks should have a formal disclosure policy
  approved by the board of directors. This policy
  should describe the banks objective and strategy
  for the public disclosure of information on its
  financial condition and performance. In
  addition, banks should implement a process for
  assessing the appropriateness of their
  disclosure, including the frequency of
  disclosure.

36
Other aspects of the Third Pillar (1)

• Distinction between core and supplementary
  information
• former should be disclosed by all banks
• latter should also be disclosed, by sophisticated
  internationally active banks at least
• Supervisors should enforce disclosure
• disallow use of internal methodologies or lower
  risk weights if relevant disclosure not made

37
Other aspects of the Third Pillar (2)

• Frequency of disclosure should generally be
  half-yearly, though in some cases may need to be
  quarterly or even as soon as possible after
  material events
• Basel Committee has provided templates for
  disclosure of the various items to encourage
  comparability

38
Four main areas of disclosure (1)

• Scope of application of the New Accord
• which corporate entities within a banking group
  are included in the calculation of capital
  adequacy and which are left out
• Structure of capital
• nature, components and features of capital, e.g.
  breakdown of Tier 1 and Tier 2 capital,
  accounting policies and the terms and conditions
  of capital instruments

39
Four main areas of disclosure (2)

• Risk exposures and assessment
• amount and breakdown of various types of risks
  and explanation of how these risks are managed,
  details of use of external rating agencies or
  internal ratings for measuring credit risk,
  details of use of collateral or guarantees for
  mitigating credit risk
• Capital adequacy
• capital requirements for the various types of
  risk and the percentage of capital to total
  capital requirements

40
Initial market reactions

• Banks generally accept the principle of greater
  disclosure as the price for greater management
  discretion in setting capital requirements
• But some concerns, e.g.
• cost of compliance
• need to focus on quality rather than just
  quantity
• potential loss of proprietary information
• lack of a level playing field with non-bank
  competitors
• possible misunderstanding by bank analysts
• Industry will be working on counter-proposals
  during the consultation period

41
Conclusions

• Sound banks depend on three disciplines
• internal discipline of the bank itself
• external discipline of the supervisor
• external discipline of the market
• The latter requires an adequate level of public
  disclosure
• But more information is not always better
• Disclosure doesnt always achieve transparency
• Quality counts and comparability is essential